Fixed income is an asset class that is a commonly held investment because it helps preserve capital. Fixed-income investments, or bonds as they are commonly known, typically provide a premium above inflation and experience less return volatility compared with shares.
Fixed income is held for the steady income stream the regular coupon payments provide.
Bonds can offer diversification benefits because they often perform in the opposite direction to shares. Bond investments, therefore, help to lower the risk level within a diversified portfolio.
What are bonds?
One way a government or a company can obtain the money they need to fund their projects or initiatives is to sell bonds.
In other words, a bond is a loan sold or issued by the borrower (issuer) and purchased by the lender (investor). The borrower in turn makes two key promises to the lender:
What determines the level of coupons to pay? There are a few factors to consider:
The following are some commonly used terms that may be useful when talking about bonds. (We will explain elsewhere what yield means.)
|Face Value||The initial loan amount||$500,000|
|Coupon||A set level of interest paid per face value||5% p.a.|
|Yield||The annualised return a bond offers at its current price||With a 5% coupon rate, if the current bond price < 100, yield > 5%
If current bond price > 100, yield < 5%
|Maturity||The pre-determined date of loan repayment||10 years from now|
How do bonds make money for you?
Bonds (with the exception of zero coupon bonds discussed below) pay out a regular stream of interest known as coupon payments. There are several ways the bond issuer can go about this, depending on the type of bond. Below are some examples:
However, coupons are just part of the total returns that investors can receive when investing in bonds. The other source of return is capital gain. Bonds, like stocks, are subject to market conditions and their value can fluctuate (or move up and down) from the time they are issued until their maturity. Factors affecting the price of a bond during its life are discussed later.
The relationship between yield and price
The price of a bond can fluctuate throughout its life. This fluctuation is in response to the current interest rate environment. Since bonds cannot change their coupon rates to align with current interest rates, their prices will adjust accordingly so that their yields can do so.
What is yield? Put simply, it is a measure of return available from a bond. Take the example of a 10 year bond with a par value of $100, which pays out a 5% coupon rate (i.e. $5) each year. The yield on the bond is therefore 5%.
Suppose interest rates in the market increase to 6%. Because the coupon rate on the bond is already fixed, the price of the bond will have to drop proportionately so that the return from the bond (i.e. the yield) increases to 6%. In other words, the price of the bond will drop to about $83 so that the yield on the bond will increase to 6% ($5 / $83), in line with prevailing interest rates. This way, the bond will not be any less attractive than any other investments in the market.
Conversely, should prevailing interest rates drop to 4%, the price of the bond will increase to about $125 so that the yield on the bond will decrease to 4% ($5/$125)
Therefore, the price of a bond is inversely related to its yield.
A term that is commonly used is the yield-to-maturity (usually abbreviated to YTM). YTM is a useful measure, especially when comparing bonds of different coupons and maturities. It assumes that any coupons received from the bond are reinvested at a rate equal to the YTM. The calculation for YTM is based on the coupon rate and length of time to maturity, as well as the market price.
What is duration and how is it used?
So far, we have seen how bond prices move in relation to interest rates. However, how can we know how much a bond’s price will change in response to a move in interest rates?
This is where duration comes in. Duration expresses the sensitivity of a bond’s price to changes in interest rates and tells us the approximate change in the price of a bond in the event of a 1% change in interest rates. Duration is stated in years. For example, a two-year duration means that the bond will decrease in value by 2% if interest rates rise by 1% and increase in value by 2% if interest rates fall by 1%.
|The sensitivity of a bond’s price to changes in interest rates|
|Higher duration bonds are more sensitive to interest rate changes|
|Bond A||Bond B||Bond C||Bond D|
|Term to maturity (years)||5||10||10||10|
|Price change for 1% rise in rates||-4.55%||-8.11%||-7.54%||-7.04%|
|Price change for 1% fall in rates||+4.55%.||+8.11%||+7.54%||+7.04%|
|Bond prices are impacted by interest rate changes – bonds with higher durations carry more risk above and have higher price volatility than bonds with lower durations|
In other words, duration can be an indicator of how risky a bond is. For example, if you are not risk averse and think that interest rates are going down, you should buy a bond with a longer duration, so that you will benefit more from a fall in interest rates compared to a shorter duration bond. Conversely, should your view be wrong and interest rates increase instead, you would suffer a greater loss.
Bond Yield and Time to Maturity
The yield curve is the relationship between the interest rate and the time to maturity of the debt for a given borrower in a given currency.
Generally speaking, yield curves can be broadly classified into three main types.
|1. Normal Yield Curve – Yield curves are usually upward sloping, meaning the longer the maturity, the higher the return (yield). A longer-term bond usually involves more risk that the borrower will default, or interest rates will change, or the lender will find a better potential use for their money. Investors therefore demand greater compensation for the uncertainty over a longer time period, also known as term premium.|
|2. Inverted Yield Curve – An inverted yield curve arises when short term interest rates are high relative to long-term expectations. This curve indicates that investors expect interest rates to be lower in the future. Term premium in this instance is negative.|
|3. Flat Yield Curve - This curve indicates the yields of bonds with different maturities are relatively constant, and is seen when interest rates are expected to decline moderately but offset by positive term premium.|
A credit rating agency is an independent rating agency that analyses and publishes a credit rating on companies and governments which issue bonds. These rating agencies periodically review their ratings and occasionally move them higher or lower. When a rating change occurs it is normal for the outstanding bonds affected to increase in value (in an upgrade) or decrease in value (in a downgrade). Common rating agencies include Moody’s, Standard & Poors and Fitch, and rating decisions are based on factors such as:
|Credit risk||Moody's||Standard & Poor's|
|Investment grade (High grade)|
|High quality (very strong)||Aa||AA|
|Upper medium grade (strong)||A||A|
|Non-investment grade (High yield)|
|Lower medium grade (somewhat speculative)||Ba||BB|
|Low grade (speculative)||B||B|
|Poor quality (may default)||Caa||CCC|
|No interest being paid or bankruptcy petition flied||C||C|
Put simply, a rating assigned to a bond issuer can be a guide to the question: "when I lend my money to this company today, what is the possibility that I will not get my money back?"
Each credit agency has its own grading system. Standard & Poor’s grading system, for example, ranges from AAA (highest quality) to D (in default). Ratings of AAA, AA, A and BBB are considered investment grade (or high grade), while any rating below BBB is considered non-investment grade (high yield).
Risks involved in bond investing
There are a number of risk factors that affect bond investing, most of which are interrelated.
Interest rate/duration risk – As previously mentioned, bond investments are sensitive to the movements in domestic and international interest rates (or yield), and the magnitude of this risk is measured by duration. The level of duration is therefore an important aspect to consider when investing in a bond or a portfolio of bonds.
Credit / Default risks – The possibility that a bond issuer will default means that the issuer will be unable to make interest or principal payments when they are due. Bonds issued by government or government agencies or government-sponsored enterprises, in the majority, are less likely to suffer from default due to their ability to raise taxes. In comparison, bonds issued by corporations, particularly high yield bonds, have a higher probability of default.
Liquidity risk – There is a probability of loss arising from the difficulty of selling an asset because of insufficient buyers or sellers in the open market. An investment may sometimes need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the liquidation or limit the funds that can be generated from the asset. Liquidity risk may be quantified as the difference between an asset's value and the price at which it can likely be sold. To manage liquidity risk, investors can consider investing in higher quality assets, such as investment grade bonds.
Types of bonds issued today
Now that you're more familiar with bond terms and features, we're going to discuss some of the different types of bonds issued today. Bonds come in all shapes and sizes, and indeed the investment universe for this asset class is large and diverse. Common types of bonds are described below:
Different bonds are suitable in different economic cycles
Regardless of which point of the economic cycle we are currently at, there are always opportunities for bond fund managers to make money from the asset class. This is because different types of bonds perform differently at different points of the economic cycle.
For example, during a period of economic downturn, government bonds tend to outperform as risk aversion increases and interest rates fall. On the other hand, during a period of economic recovery, corporates (particularly high yield bonds) would tend to outperform as credit conditions improve.
Advantages of bond funds
Unlike listed shares, where securities are traded on centralised exchanges, most individual bonds are bought and sold in the over-the-counter (OTC) market where trading is done directly between two parties. In the OTC market, quantity, price and settlement (amongst other things) are negotiable. The trading parties comprise of securities firms, banks, brokers or dealers. Often, brokers will not charge a commission to buy bonds but will charge a spread (bid-offer) to transact. Australian investors can purchase bonds through the primary market, or buy and sell bonds in the secondary market. Many dealers keep inventories of a variety of outstanding (i.e. previously issued) bonds.
High minimum purchase amounts (e.g. $500,000) prevent many individual investors participating directly in the bond market. However, bond funds such as the Schroder Fixed Income Fund offer Australian investors a more accessible option to invest in the bond markets. Bond funds, like stock funds, offer professional selection and management of a portfolio of securities. They allow an investor to diversify risks across a broad range of issues and offer a number of other conveniences, such as the option of having interest payments either reinvested or distributed periodically. Fees and charges apply when investing in both bonds and bond funds. General charges of bond funds include management and transaction costs.
Investing directly in bonds versus through bond funds
Having explained the technicalities of how a bond works, it is not hard to see why bonds can be attractive investments. Besides diversification, they also offer higher potential returns over cash deposit rates, but without the volatility of shares.
The easiest way to get started is to invest in a bond fund rather than investing directly. Here are the reasons:
Schroders' approach to fixed income
At Schroders, we believe the fixed income universe is extremely diverse. This breadth, and the diversity of possible risk and return outcomes, means active management is essential. Schroders’ employs a top down approach to managing bonds and aims to add value through four levers:
Why Schroders for bonds?
Investment in the Schroder Fixed Income Fund may be made on an application form in the Product Disclosure Statement (PDS) dated 4 August 2014 which is available from Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFS Licence 226473) website www.schroders.com.au. The information contained in this flyer is general information only. It does not contain and should not be taken as containing any financial product advice or financial product recommendations. Before acting on the information contained in this flyer you should obtain a copy of the PDS and consider the appropriateness of the information in regard to your objective, financial situation and needs before making any decision about whether to invest, or continue to hold. Total returns are calculated using exit price to exit price, after fees and expenses, and assuming reinvestment of income. Gross returns are calculated using exit price to exit price and are gross of fees and expenses. The repayment of capital and performance in any of the detailed funds are not guaranteed by Schroders or any company in the Schroders Group. Opinions constitute our judgement at the time of issue and are subject to change. Past performance is not an indicator of future performance. For security reasons, telephone calls may be taped.
Q: I purchase a A$500,000, ten-year bond with a coupon rate of 5%. What will your interest payments be each year?
A: The coupon rate is 5%, which means you receive A$25,000 each year (5% of A$500,000).
Q: I own a 6% bond and want to sell it in a year. Do you hope that interest rates rise or fall?
A: You hope that interest rates fall. When interest rates fall, newly issued bonds will likely offer a lower interest rate. So your bond paying 6% will be more appealing to investors and thus command a high price.
Q: I buy a bond and intend to hold it to maturity. Is the bond’s changing price and yield a concern to you?
A: No, if you intend to hold a bond to maturity, you typically can ignore its fluctuating price and yield, assuming that the issuer is still able to pay you as scheduled.
Q: I sometimes hear that rising bond prices are a good thing and that rising bond yields are also a good thing. How can both be true when they move in opposite directions?
A: Rising bond prices are good news for a person who owns a bond. They mean that investors are willing to pay more for the bond. Rising yields are good news for a person who wants to buy a bond. Remember that rising yields typically mean that bond prices are dropping. The buyer can get the same interest payments for less money.
Q: I own a corporate bond and the issuing company reports a large operating loss for its fiscal quarter. What concern should you have related to the bond’s rating?
A: This could indicate further financial problems with the issuer. Negative news would impact price adversely and if you intend to sell the bond, you may not be able to command as high a price as you paid for it. Credit Rating Agencies such as Standard & Poor’s may also downgrade the bond’s rating.