Bond Investing Explained: Risk, Interest rates, And Bond Prices
Technically, a bond is just a loan. But bond investing is a different ball game altogether. In the investment world, bonds are considered the safer and more boring cousins of shares. However, they’re also one of the most mathematically fascinating asset classes out there.
In this post, I’ll explain how bonds work, and let you know how to invest in them. It’s time to get technical!
Why companies, governments or other entities issue bonds to investors
Betty Bondar is the Chief Executive Officer (CEO) at Bondar ltd, a large wine producing conglomerate listed on the London Stock Exchange. After an intense Board meeting, Betty’s Board of Directors agrees to buy several prime vineyards in Argentina to expand the business into South America.
The vineyards aren’t cheap, so Bondar issues £500 million worth of bonds to the public to raise the money to buy them. In other words, Bondar Wineries is borrowing £500 million from its bond investors.
Why do investors buy bonds?
You decide to buy some Bondar bonds directly from the company. This means you’re lending money to Bondar.
In exchange for the cash you lend to the company, you receive interest payments (called coupons) every year from Bondar until the bonds mature in 10 years’ time.
When the bonds mature, Bondar pays you back the cash you lent to it when you originally bought the bonds. Bondar originally issued the bonds at their par value (usually 100).
You can think of the par value of a bond as a ‘deposit’…
You pay a £100 deposit up front to receive interest payments from Bondar and when the loan matures in 10 years’ time, you get your £100 deposit back.
This sounds like a pretty good deal, and it can be, as long as you consider the risks involved.
Before we move onto that, the diagram below recaps the basic mechanics of how bonds work.
How risk affects the interest rate of a bond
Before you can take out a mortgage on your home, your bank or building society will rigorously assess your credit risk. It will look at things like:
- Your annual income.
- Your total net worth.
- Whether you have a history of paying your credit card on time.
When you invest in bonds, you get to ‘be the bank’ because you’re the one lending the money.
Sticking with the earlier example, Bondar Ltd is a large, financially stable company, and has an excellent track record of paying back its previous debt. Knowing this, you’d feel quite confident that if you buy a Bondar bond, you’ll receive all your interest payments plus the final par value of the bond when it matures in 10 years time.
But what if you bought a bond in a small, financially unstable start-up company?
In this case, you’d want to be compensated for taking on more lending risk.
Just like your bank would charge a higher interest rate on a loan to a dodgy borrower, so too would you demand a higher coupon on your bond in the start-up company.
The start-up company bonds would pay a higher interest rate than the Bondar bonds because they are a riskier investment.
Bond credit ratings
The lower the credit rating of a borrower, the higher the risk of lending money to that borrower.
Credit Rating Agencies such as Moody’s, Standard & Poors or Fitch Ratings will analyse the credit quality of Bondar ltd and other companies to determine the risk of them not being able to meet their debt repayments.
Ratings can range from excellent credit quality (AAA) to already in default (D).
Government-issued bonds are likely candidates for AAA ratings because governments can print money to pay back their bond obligations if they need to.
If you own a bond with a bad credit rating, you would want a higher interest rate on that bond as compensation for taking on more risk (the risk is that you won’t get all the money you’re owed on the bond as it becomes due).
If you own a bond with a good credit rating, then you would only need a lower interest rate on that bond as an incentive for buying it.
Bonds and the bond market
After a company issues a bond to its original investors at the par price, 100, investors can trade that bond among themselves in the bond market.
The price of the bond at any point in time is then equal to what someone is willing to pay for it. This can be greater than or less than the 100 par price.
Say you wanted to sell your Bondar bond 3 years after you bought it…
Because the bond is a 10-year loan, you would still be owed 7 years’ worth of interest payments on your bond after 3 years. Another investor could then buy your bond for cash and in exchange receive the remaining interest payments each year for the next 7 years, plus the £100 par value (deposit) of the bond after 7 years is up.
Assume the Bondar credit rating was ‘A’ when you bought your bond for £100 three years ago. Three years later, when you want to sell your bond, Bondar ltd is performing spectacularly well and is generating lots of profit. Because of its improved company performance, Bondar’s credit rating has jumped from ‘A’ to ‘AA’.
So what happened to the price of the bond? You guessed it, it went up!
Note: the credit rating of a bond doesn’t need to change for its price to change. Like all things in the market, supply and demand drive the price.
The inverse relationship between bonds and interest rates
The yield on a bond is the interest payment you receive as a percentage of the current bond price. Interest payments, or coupons, are a fixed percentage of the par value or ‘deposit’ amount of the original bond issue – i.e. they don’t change throughout the life of the bond.
So if the bond price were to go down in the bond market, then the next investor who owned the bond would have paid less for it than the original investor and still get the same coupon.
Therefore, if the bond price goes down, the fixed interest payment as a percentage of the changing bond price goes up. This is the cardinal rule of bonds:
The lower the bond price, the higher the bond yield, and visa-versa.
Final thoughts in bond investing
We have barely scratched the surface of how deep the bond rabbit hole can go.
Some of the most extreme academics on earth spend their lives studying the mathematical intricacies of bond investing. Here’s why:
- You can buy bonds of all maturity ranges (for example 1,5,10 or even 50 year bonds) and credit qualities (for instance AAA, A, B+, B-, CCC).
- Bonds can be issued by governments, government agencies, large companies, small companies or charities.
- Bonds can be backed by pools of mortgage, credit card, or even student loans.
- They can have fixed coupons, variable coupons, or even coupons linked to inflation.
- They may have derivatives attached to them called embedded call options where the borrower has the option to terminate the bond at a specific date.
- Or, they could have embedded put options where you have the option to sell the bond back to the issuer before your coupons expire.
- Each bond issuance can have multiple layers called tranches, each with varying degrees of credit quality, where junior tranches absorb the risk of the senior tranches, or a structure where the senior tranches absorb another type of risk on the junior tranches.
The global bond universe is both infinite and spectacular. It dwarfs the global share universe in size and variation by a country mile. Knowing where to begin can be a daunting task.
But you don’t need to be a ‘bond geek’ to make money though bond investing.
You can earn investment returns on bonds through interest payments and price growth, just like you can with shares. And, just like with shares, you can invest in bonds indirectly through funds.
If you fancy going further down bond rabbit hole, drop me an email and I’ll try to answer your question.