Bonds, also known as fixed income securities, are the second most important category of investment after equities. Used as hedges and a provider of fixed income coupons, they are a key part of most portfolios. Older investors and those near to retirement tend to keep the majority of their holdings in bonds, as they experience less volatility than other assets, especially equities. Divided into many subtypes according to their issuer, payment characteristics and credit worthiness, understanding fixed income is a key factor in developing a rounded portfolio.
What are bonds?
Bonds are fixed income debt securities. They involve buying the debt of a company, government or supernational organisation in exchange for a fixed return known as a coupon. Bonds are almost always priced with 100 as ‘parity’, but can freely trade above or below that figure. Bonds trading significantly below parity (eg <90) are likely under serious stress, and the market expects that they could default.
Bonds have an expiry date, at which the value (at parity) of the bond will be repaid, and before that date they will pay out a coupon at regular intervals. So if you buy a bond at $100 (parity) with a 5% coupon and it expires next year, you will make the 5% coupon ($5) and have your $100 returned for an overall yield of 5%. Should you buy the same bond at $99, the yield will be 6%, as you will receive the 5% coupon (calculated from the parity value), as well as the parity value of the bond at expiry. By contrast, buying the same bond at $101 would result in a 4% yield.
What types of bond are available?
Providers such as Saxo Markets offer a range of bonds, with the most popular government and corporate bonds. Other types exist, such as municipal bonds issued by local governments (particularly in the US) and debt issued by international organisations like the World Bank. The government debts of the US and UK have specific names – Treasuries and Gilts respectively – but in every other way are identical to other corporate or government bonds.
The first thing to check, along with price and expiry date, is the credit rating of the bond. Assets such as US Treasuries are considered ‘risk-free’, since the expected risk of the US Government defaulting on its debts is zero, and accordingly the yields are very low, typically under 1% in recent years. The national debt of other countries, particularly in emerging markets or South America, can be far higher, but the risks associated also increase. A few countries, especially Germany, have had negative-yielding government debt in recent years. Bonds with very low yields typically have higher credit ratings, which are provided by external agencies such as Moodys, Standard and Poor, and Fitch.
Understanding credit ratings
There are subtle differences between the scale used by Moodys and the other two – these are normally obvious in context. In Fitch and S&P, the cut-off for ‘investment grade’ – the only bonds a retail trader should touch – is BBB-. The scale runs from AAA down to D (Moodys only goes so far as C), and all ratings below BBB- are considered ‘junk bonds’. A rating of C or D indicates debt that is already in default or about to be; these are still traded by some funds, who hope to win favourable payouts in restructuring of their debt.
Credit ratings above investment grade have a fairly low chance of defaulting, although these ratings are continually updated to reflect conditions, and changes can happen quite rapidly. The yield of lower-rated bonds will by higher, both because companies with poor credit ratings are forced to reimburse investors with higher coupons, and because they often trade below parity. For example, an AAA rated company may be able to issue bonds with a 2% coupon, and will frequently trade over parity, but a less financially sound company with a BBB- rating may need to offer a 7% coupon to reward investors for taking on the risk of their debt.
Bonds in portfolio theory
Standard portfolio theory recommends investors to use a mixture of stocks and bonds, with more stocks taken on to increase market risk and potential returns, and bonds used as a hedge. As you near retirement, you should shift towards a higher percentage of bonds, as they generate income directly through the coupon and are less liable to sudden swings in price. Investors with a long distance to retirement are normally better off investing mostly in equities, although having a small portion set aside to bonds can help protect against volatility and market downturns.
Junk bonds and corporate debt tends to track the equity market more closely, and are less useful as hedges, although they come with higher returns. Government bonds typically see very stable prices, as at least in developed markets non-payment is extremely rare. Be wary of bonds with very high coupons or those trading below par; this is often a sign of underlying problems at the issuer. Equally, a bond trading far above parity will likely yield nothing or even negatively – some bonds can trade as high as $120, completely wiping out any return from the coupon.
Conclusion
Bonds are one of the most important asset classes for retail and professional investors. Somewhat neglected compared to equities, developing an understanding of the fixed income market is indispensable to your overall market knowledge. Retail investors close to retirement, or those who are very risk adverse, will likely have significant bond holdings in their portfolio, often split between government debt and high-quality corporate issuers. Remember to avoid risky high yield debt, as though profitable trades are possible in that segment, they require a detailed understanding of the process of bankruptcy and distressed credit, and are not suitable to the typical investor. Corporate debt is generally considered more risky than government, and local government or municipal bonds are more risky than national debt. Within national debt, countries in economic distress, political turmoil and poorer countries more generally typically have higher yields, lower prices and worse credit ratings. Whatever you invest in, make sure you research the issuer before buying.
