Bond Investment Fundamentals

 

When you invest in bonds, you are typically lending money to a government or company at an agreed interest rate for a specified period of time.  They, in return promise to pay you interest at regular intervals and repay your loan at the end of the term.

Bond investment therefore can appear disarmingly simple when compared to stocks; however, beware the devil in the detail.

Let’s cut through some of the jargon by examining the fundamentals of investing and some of the quirks of bonds. This three-part blog considers RIM Securities Shifting Risk Preference research in the context of bond fundamentals.

Bonds are referred to as fixed interest securities because the coupon payment date, coupon rate, face value (i.e. principal paid at maturity) and maturity date are all fixed. The yield (1) and price fluctuate constantly as a result of changing market conditions.  Rarely does the yield equal the coupon rate or the price equal the face value.

Prices fall when interest rates rise

Bond prices fall when interest rates rise. The statement sounds counter-intuitive unless we consider all the fixed features of a bond. As an SMSF Trustee, let us pretend we are thinking about selling a bond one year after purchase.  See the purchase terms in the table below:

The purchase price of the bond and face value are equal because the coupon rate equals the purchase yield.  A yield hardly ever equals the coupon rate for long but it might happen when the bond is first issued. In reality, market forces alter the bond yield, and hence the price, the instant the bond enters the secondary market.

One year on, the market yield is 6% p. a. causing the bond’s market price to fall from $100.00 to $93.12. Of course, this is only a problem if we sell the bond before maturity. Holding the bond to maturity is a legitimate strategy that would avoid the SMSF Trustee realising a loss.

Bonds Fixed Features

The lower price makes sense when the bond’s fixed features are considered (i.e. coupon rate, coupon payment, coupon payment date, face value and maturity date).

Only the price and yield can fluctuate to reflect changes in the market value. The only way the buyer can earn the higher market yield of 6% p. a. is for the seller to accept a lower price. In this scenario, the price will be lower than the face value of the bond.
The bond is said to be trading at a discount to the face value.

This relationship holds true every time a bond is sold, if the yield is higher than it was at the time of purchase.
A decrease in the yield would have the opposite effect.

Market dynamics and interest rate movements

Issuer specific and general market (macro) factors influence the bond price.  Monetary policy is an example of a macro factor.

Inflation is a factor that can prompt the RBA to increase the cash rate (i.e. tightens monetary policy). The relationship between a bond price and the RBA cash rate is not necessarily one to one.  For example, a 0.25% increase in the RBA cash rate does not necessarily result in an immediate increase in all bond yields by the exact same amount, but the rates are highly correlated.

Shifting risk preferences

RIM Securities research found that investors appeared to shy away from fixed coupons even though interest rates stayed in a similar range in 2015 and 2016.

Do investors expect the next interest rate moves to be up fearing a fall in the price of their bonds?  Commentary discussing an increase in Australian interest rates has increased and U.S. interest rates have already moved up albeit by a small amount.

Credit risk is an example of an issuer specific factor that has a major influence on a bond’s market price and yield.  RIM Securities research also identified changes in credit exposures as an area of interest.

Coming Up – look out in a few weeks for Part two where we will consider the trend in increasing credit exposures.

About RIM Securities
RIM Securities Limited is one of the best kept secrets in Australia and acts as the fixed interest engine for Australian investors by sourcing and executing fixed income securities. The business has established itself as a leader and key player in defensive assets placing in excess of AU$15 billion over the past 12 years. The firm is Brisbane-based and was established in 2004.  It is majority owned by Trustees Australia (“TAU”), which became listed on the ASX in 1987.

References

(1) The market interest rate or rate of return for a bond
(2) Also referred to as market yield or yield to maturity (YTM) ie. the interest rate an investor would receive if they purchased the bond on the open market.
(3) For ease, the price impact of the shorter term to maturity is not disclosed

 

Register

Loading...

Request Latest Bonds