Let’s talk about bonds

Bonds are often seen as the boring cousin to equities and stock investing, but they are actually a fundamental part of the global investment universe. In actual fact, the bond market is larger in terms of capitalisation at the global level than the equity market. What this means in simple terms is that there are more bonds and there's more money in bond investing than equity investing. But what are bonds and what do you need to know about them? Let's dig into it.

Back to basics

A bond is a debt instrument; the borrower is a company or a government and the lender is the investor.

Bonds are issued by the borrower and purchased by the investor for a fixed term, and during its lifetime the borrower pays the investor interest, which is called the coupon. At the end of the term, or at maturity, the principal (the original amount loaned) is repaid.

Why would you own a bond?

Bonds have traditionally been used as the main diversifier from equity risk; this is why we have the concept of a 60:40 portfolio (with a 60% allocation to equities and a 40% allocation to bonds).

Bonds typically behave differently to equities in the short-term. Whilst they are not always negatively correlated (when the price of one goes up, the price of the other goes down), bonds are almost always less volatile than equities. They are therefore a useful tool to reduce the correlation of your portfolio to equity market movements, not forgetting that there are other asset classes that you can use to diversify your portfolio, such as property, infrastructure, commodities and other alternatives such as long/short funds.

In addition to providing diversification in terms of volatility, bonds also provide the investor with an income yield. This is why they are often referred to as ‘fixed income’ investments as the bond pays a fixed, set coupon throughout its term.

How can you access bonds?

As with many other types of investments, bonds can be purchased at the point of issue (called the primary market), where the investor buys the bond directly from the issuer. The bonds can then be traded in the secondary market.

However, whilst a small number of bonds are traded through exchanges like equities, most are traded ‘over-the-counter’ by brokers. The secondary market is therefore not easily accessible by retail investors and is almost exclusively reserved for institutional investors. As a result, most retail or personal investors will access bond investments via funds or collective investments.

Credit ratings are important

As with all areas of investing, there is a spectrum of risk when it comes to bond investing. Because bonds are essentially loans, every bond has an element of ‘default risk’, where there is a chance that the issuer will fail to repay the loan at the end of the term.

There are several independent credit ratings agencies, for example, Moody’s and Standard & Poor, who assess the default risk of bond issuers. Each bond issuer is then given a credit rating which serves as an indicator of the quality of the debt, or the likelihood of the loan being repaid. The exact rating format varies from agency to agency but the important thing to know is that the ratings are split between ‘Investment Grade’ and ‘High-yield’.

Investment grade bonds are the highest quality bonds (although there is still a range of quality within this definition), with a lower risk of the company or government defaulting on the debt. High-yield bonds (also referred to as ‘junk bonds’ or ‘non investment grade bonds’) are lower quality bonds, with their rating suggesting that there is more risk of the company or government not being able or willing to pay back the debt.

The credit rating given to bond issuers will determine, to some extent, the coupon that the issuer offers on their bonds. High-yield bond issuers will typically offer a higher coupon than investment-grade issuers, as investors will expect to be compensated for the additional risk in order to invest.

Interest rates

The coupons offered on bonds are also related to interest rates. Investors will expect to be compensated for taking on default risk when buying bonds. Therefore the coupon offered on new bond issues tends to be at least in line with, if not in excess of the prevailing interest rates at the time. As we’ve already covered, the actual rate will depend on who is issuing the bond, with lower-rated institutions offering a higher coupon.

What this means is that when rates are rising, or there is an expectation that rates will rise, existing bonds become less attractive as a superior rate can be found with new bond issues. You’d therefore expect the price of bonds to fall (as there would be an increase in supply in the market). Conversely, when rates are falling, or there is an expectation that rates will fall, existing bonds become more attractive and you’d expect prices to rise.

Yields and prices go hand in hand

You’ll often see reference in the press and in market commentary about bond yields rising or falling. The yield of a bond is the actual return an investor can expect from the bond relative to the price that they paid. The price paid for the bond is often different to the maturity value, as bonds are traded in the secondary market. It’s therefore possible to achieve a yield that’s higher or lower than the actual coupon rate paid on the bond.

Bond prices and bond yields have an inverse relationship; if the prices go up, the yield achieved on the bond falls and vice versa. Investors can therefore make speculative investments in bonds with the aim of achieving a capital return.

This is why, for roughly 10 years after the global financial crisis in 2008, bonds have been a relatively unattractive asset class for investors. With interest rates remaining extremely low (and even negative in Europe), the yield investors could achieve through bonds was also very low. In addition to this, the expectation was that, at some point, rates would normalise and rise again which would likely push down bond prices. Therefore not only was the income return unappealing, the outlook for capital returns wasn’t great either.

More recently, we’ve seen rising interest rates as central banks try to combat inflation. We’ve therefore also seen bond prices fall, making bonds interesting again for investors from a capital return perspective as well as for income.

Price sensitivity is a core concept

When reading about bond investing you would likely come across several references to the term duration. Whilst it isn’t necessary to understand the nuance of calculating duration when you’re investing in bond funds, it’s worth understanding the measure at a high level.

Duration is a measure of the sensitivity of the price of a bond to changes in interest rates. The higher the duration of the bond, the more the price will change as a result of changes in rates. Remember that the price of bonds has an inverse relationship to interest rates, so rising rates will result in falling prices and vice versa.

Duration is calculated using the coupon of the bond and the term, or the maturity of the bond. What this tells us, at a high level, is that the term and the yield of the bond affect its sensitivity to changes in rates. Therefore, longer-dated and higher-yield bonds are more sensitive (or higher risk) than shorter-dated, lower yielding bonds.

Why does this matter to personal investors? It informs your decision making. If you’re looking to add an allocation to bonds to reduce the volatility of your portfolio and to act as steady ‘dry powder’, you might look to allocate to short dated, high quality investment-grade bonds. If you’re looking to allocate to bonds as a speculative investment, as you think that yields are going to fall and prices will rise, you might consider longer-dated, lower-quality bonds as these will be more price sensitive to those rate or yield changes.

There are lots of options

As with almost every asset class, there are lots of different styles and types of funds available when looking to allocate to bonds.

There are active funds, where the fund manager uses their judgement to pick which investments to hold within the funds. There are also passive funds which look to replicate and track an index. You can usually find both active and passive funds that specialise in particular segments of the bond market, for example specialising in regions, styles (government debt vs. corporate) or quality (investment-grade or high yield). On TILLIT, as well as selecting between active and passive, you can filter the bond funds in our Universe by style, so that you can find exactly what you’re looking for.

There are also bond funds known as ‘strategic bonds’. These are active funds where the fund manager is not restricted to a particular region, style or quality. Because strategic bonds funds typically have a very broad spectrum within which they invest, the fund managers use their knowledge, expertise and analysis to shift and pivot the fund’s portfolio to different areas of the areas of the market where they think there is most value.

Bonds have been the traditional diversifier for equity risk for decades. Once viewed as a simple tool to generate interest income and preserve capital, bond investing has evolved into a $100 trillion marketplace, providing many opportunities for investors (1).

On TILLIT, our experts have selected a range of bond funds to feature in our Universe. Why not take a look?

Sources:

(1) Source: $100 trillion marketplace: https://europe.pimco.com/en&nb..

Date of publication: 3rd May 2023