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Investing basics: what is a bond?

Emma Rapaport  |  16 Aug 2019Text size  Decrease  Increase  |  
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As the world frets over the inverted yield curve and the ominous warning of a global recession, it’s worth examining how fixed interest, and bonds in particular, work. 

Not only is a bond an important aspect of every investor's portfolio, but the market can give us clues about how investors are feeling, the state of the economy, and how future markets may perform.

In the first of this three-part series on bonds, we'll first head over to the Morningstar Investing Classroom to learn the basics of bonds from coupons to collateral and their relationship to interest rates.

Then, Morningstar's director of investor education Karen Wallace will walk us through what a yield curve is and why bond markets are sending a big global recession warning.

And finally, we'll look at the growing pool of negative-yielding bonds, why it has come about and what it's telling us about the future.

Bonds 101: What is a bond?

At their most basic, bonds are loans.

A bond is an interest-bearing IOU between an investor and the bond issuer. Governments and companies typically issue bonds as a way of raising money to carry out objectives.

We will examine how bonds work in more detail below, but in short, when you buy a $1000 bond you're effectively lending money to the issuer, the government or company, so it can fund its spending. It agrees to pay your principal back in, say, 10 years but along the way rewards you with a small interest payment of $50 a year - a 5 per cent "coupon rate" - a couple of times a year. A stable, predictable income stream.

There are two basic types of bonds:

  • Government bonds; and
  • Corporate bonds.

Government bonds are issued by a government to support government spending. They typically offer a modest return with low risk. Corporate bonds are issued by companies and carry a higher degree of risk (should the company default) as well as return.

If you buy the bond at the date of issue and hold it for the duration of the loan agreement the interest rate is called a coupon.

Much like shares, bonds can be traded between investors. The bond issuer remains the same, but the bond is transferred to a new owner who is then paid both the interest and, at the end of the term, the lump sum.

Bonds and credit quality

The reputation of bonds is that they are the safer alternative to investing in shares. In reality, the degree of safety varies.

The same way that an investor who loans his best friend $100 can reliably expect to get the money back, lending the government money by buying a government bond is a relatively safe bet. The friend is likely to stick around and repay the loan because the friendship is valued in the same way that the government, at least here in Australia, is the least likely institution to go broke and be unable to repay its debt.

In this vein, some companies are financially stronger than others. One way that potential bondholders can gauge how safe their money will be is to look at the issuer’s credit rating. These are assigned by credit ratings agencies such as Moody’s or Fitch. Ratings of AAA+ to BBB- indicate a company is of investment grade while those from BB+ down to D are deemed sub-investment grade [also known as speculative grade].

Bonds and return levels

In theory, a rational investor would seek to put his hard-earned savings in the most secure place possible. Consequently, in a bid to entice investors, bond issuers with lower credit ratings will offer higher levels of returns.

For example, if the government is paying 4 per cent return on its bonds, then companies of investment grade – AAA+ to BBB- – may offer 5.5 per cent while issuers of sub-investment grade bonds would have to pay 7.5 per cent or 8 per cent. Picture a see-saw with credit quality on one side and rate of return on the other. When credit quality is up high then returns are lower and vice versa.

Bond pricing and interest rates

Two forces largely govern the performance of bonds: interest rate sensitivity and credit risk.

When a bond is issued, it pays a fixed rate of interest called a coupon rate until it matures. This rate is related to the prevailing interest rates and the perceived risk of the issuer. 

When you sell the bond on the secondary market before it matures, the value of the bond, not the coupon, will be affected by the market interest rates (at the time) and the length of time to maturity.

Interest rate risk is the risk that interest rate fluctuation will affect bond prices. When current interest rates are greater than a bond's coupon rate, the bond will sell below its face value at a discount. When interest rates are less than the coupon rate, the bond can be sold at a premium higher than the face value.

Example

Let's say you have a 10-year, $5,000 bond with a coupon rate of 5 per cent.

If interest rates rise, new bond issues might have coupon rates of 6 per cent. This means an investor can earn more interest from buying a new bond instead of yours. This reduces your bond's value, causing you to sell it at a discounted price.

If interest rates fall, and the coupon rate of new issues falls to 4 per cent, your bond becomes more valuable, because investors can earn more interest from buying your bond than a new issue. They may be willing to pay more than $5,000 to earn the better interest rate, allowing you to sell it for a premium.

Bond yields and market pricing

The amount of return a bond earns over time is known as its yield.

A bond's yield is its:

annual interest rate (coupon)
/divided by
its current market price.

There is an inverse relationship between a bond's yield and its price. When interest rates rise, bond prices fall (they are sold at a discount from their face value) and their yields rise to be consistent with current market conditions.

The buyer's yield will be higher than the seller's was because the buyer paid less for the bond, yet receives the same coupon payments while the redemption price is higher than the purchase price.

Example

Suppose interest rates have risen from 5 per cent to 6.25 per cent, meaning bond prices have fallen. You can now buy a bond with a face value of $1,000 and a coupon rate of 5 per cent ($50 per year) for $800, making your bond's yield consistent with current interest rates (50/800 x 100 = 6.25 per cent).

The reverse is also true. When interest rates fall, bond prices rise and their yields fall to be consistent with current rates.

is a reporter for Morningstar.com.au

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