Bonds: Everything You Always Wanted To Ask

Australia | May 05 2021

FNArena's series on bond investment continues with further information and explanation

-Australians shy away from corporate bonds
-How bonds work
-Technical terms
-How to invest

By Mark Story

Given bonds come in so many different varieties, and are heavily influenced by macroeconomic and other forces, none the least being central bank policy, it’s hardly surprising bonds are the asset class Australian investors struggle with most.

For example, according to Deloitte Access Economics, private Australian investors hold less than 1% of all corporate bonds on issue in Australia, compared to almost 20% in the US.

As a defensive asset that provides a stable source of income, while protecting the money you invest, bonds can be a worthwhile way to diversify any portfolio. While no Australian government has ever defaulted on the debt it owes bondholders, a lot of investors steer clear of bonds, simply because they don’t understand them and hence lack the confidence to buy them.

To make matters worse, the advice sector has not been as effective as it should be at championing bonds, and the role they can play alongside other asset classes.

With all of the above in mind, and following questions and enquiries from investors in recent weeks, FNArena will be running a series of highly focussed short-form articles on bonds within an Australian context.

While these articles are not designed to provide definitive chapter and verse, they will progressively bootstrap your knowledge base of all things related to bonds.

Each article will simply and unambiguously address a handful of key fundamentals one must grasp before dipping one’s toes in the bond market.

What exactly are bonds?

For a beginners’ guide to government bonds, see Why All This Fuss Over Bond Yields? (https://www.fnarena.com/index.php/2021/03/31/why-all-this-fuss-over-bond-yields/ )

A bond is what’s called a debt instrument, and like other debt instruments sitting under the fixed income asset class umbrella (like term deposits), bonds are a form of lending. But when it comes to bonds, you’re doing the lending typically to fund government or corporate activity.

As the bond issuer, a government or corporate entity undertakes to pay you (as the creditor) regular interest plus its face value in exchange for your loan. But while governments that borrow money in their own currency are considered risk free – meaning they’ll never really default – private-sector borrowers are riskier to lend money to, and this explains why they pay a higher rate of interest.

So if the five-year bond rate is, say, 1.5%, you’d need a corporate rate considerably higher over the same term to make it worth your while taking on the added risk. When it comes to government bonds, the rates on offer are typically a function of what the market expects the average future central bank cash rate setting to be, among other factors.

While many fundamental and technical factors go into determining the bond rate, one useful example is the outlook for inflation. As a case point, if inflation is likely to exceed a central bank’s expectations in future years, the market will factor in rising interest rates on the expectation the central bank will lift interest rates to bring inflation back within its comfort level.

With bonds, you also get to decide how long you lend your money for – and the terms (loan duration) can vary from one to ten years-plus – and how your interest is paid.

There are three types of interest you can be paid, depending on which option you choose. For example, a fixed rate when the bond is issued stays the same assuming you hold the bond until maturity date. In bond-speak, these interest rate payments are referred to as fixed coupon rate, and represent the yield the bond offered on its issue date.

There are also floating rates, which by definition can go up or down over the term of the bond. With floating rates, the coupon payments you receive are based on an underlying interest rate, plus a specified percentage or margin.

It’s not rocket science, your coupon payments (on a floating rate) will rise if interest rates go up and fall if they go down. Once the pre-determined length (aka the duration) of the loan ends, the bond issuer will repay you back the original amount they borrowed from you.

Then there are indexed bonds where the coupon payments (and the face value) increase in line with changes in the CPI, hence offering protection against inflation. (It can be argued most floating rates equally offer protection against inflation. Fixed coupons do not).

In the event that you decide to sell your bond on the secondary market before maturity, there’s no guarantee you’ll receive what you paid for it. If you sell a bond before maturity you’ll have to settle for the market value, which depending on market interest rates and supply and demand, could be more or less than what you paid for it (the face value).

The demand for a bond on the secondary market will be determined by a number of factors, including the bond's maturity date, yield, and the coupon payments left to be paid out.

If you have no specific maturity date in mind when investing in bonds, the market will typically indicate what duration will complement the best outcome. For example, during a period of economic downturn, long-term bonds tend to complement a period of declining interest rates, and vice versa.

To a large extent the fortunes of bonds are impacted by the prevailing interest rate environment. To properly understand bonds, you need to remember that bond yields move in the opposite direction to bond prices. If interest rates go up, the bond will trade at a discount because newly issued bonds will pay investors higher coupon rates than old ones, and the opposite also applies.

So the longer the duration, the more exposed the bond will be to changes in interest rates.

Four things you must understand about bonds

-As a fixed-income instrument, they represent a loan by an investor to a borrower, typically a company or a government

-They have an end date, when the principal of the loan is due to be paid to the bondholder

-They’re easily tradable, but often only in larger amounts (though this is changing, somewhat)

-Bond investors must legally be repaid their capital by maturity, which is why they’re considered lower risk than shares or real property.

How bonds work

All bonds have a set value (called the face value) when they’re first issued, typically at a nominal value of $100 and assuming you hold a bond until maturity, this is the amount you’ll get back.

However, the current yield is the annual interest payment calculated as a percentage of the bond’s market price. While AAA-rated government bonds do provide an enviable level of credit quality, there’s no certainty during bull markets they will trade at premiums to their $100 face value.

For example, if the central bank lowers interest rates from 3% to 2% the bond you bought with a coupon rate of 3% would now be worth more in price than a new bond issued with a 2% coupon rate.

Here’s a useful insight into how bonds actually work.

An attractive annual coupon might be expected to offer, for argument’s sake 5.25% to 6.25%. But it’s also important to remember it’s not uncommon for capital values to exceed $110. Hence, the further out that (fixed income) instrument is dated, the higher the capital value is likely to be.

Once you see what can happen if bonds are held to maturity, you’ll start to understand why portfolios that hold bonds need to be actively managed, to ensure you’re not left out of the money.

For example, if in the lead-up to maturity, yields move higher as a bull market in government bonds comes to an end, and your portfolios isn’t actively managed, a move higher in yields will result in lower capital values and potentially negative returns as the value of coupons are offset by higher capital losses.

The combined impact of solid annual returns, plus capital losses on maturity (once you realise the bond’s $100 face value), is a ‘real’ yield of between 2.5% and 3.5%.

Here’s another way to look at it

If all this sounds a little fuzzy, here’s a classic example to help clarify:

A Treasury bond is due to mature in five years, offering an attractive annual coupon of 5.5% based upon a purchase price of $100. The market has rallied and the bond is now trading at $114.

Purchasing the bond at $114 results in a yield to maturity of 2.8%. If you’re considering adding bonds to your portfolio, use this calculation to figure out how much you will earn (the bond’s yield if held until maturity):

Current Yield = (Annual Dollar Interest Paid / Market Price) x 100%.

A bond with a $100 par value, trading at the discounted price of $95.92 and paying a coupon rate of 5%, would have a current yield of 5.21%.

(0.05 x $100) / $95.92) x 100% = 5.21%.

Maybe the best way to explain this is via the share market, as most investors draw their personal experiences and insights from the ASX.

The current board at Telstra has indicated shareholders can expect an annual payout, in two tranches, of 16c.

With Telstra shares trading at $3.33, this implies the yield on offer is 4.8%. However, it wasn’t that long ago those shares were trading at $2.70. At that price, the yield on the same payout of 16c would have been 5.92%.

If we are to assume Telstra shares might be on their way to $3.50, or maybe even $4.00, and dividends remain at 16c, then the yield on offer at those prices will be 4.57% and 4% respectively.

This is the same principle that applies to bonds.

Technical terms you need understand before buying bonds

While there are a number of key terms you really need to grasp before you buy bonds, the techno-jargon the industry loves to use can make it appear a lot more complex than it needs to be.

With that in mind, we’ve stripped down these terms and put them into plain English.

  • Maturity date: Is the time frame within which the bond is due to be repaid. The longer the maturity, the higher the yield tends to be, with investors wanting to be rewarded with a higher rate for lending for a longer term.
  • Rate or running yield: Is the market interest rate of a particular bond for a particular maturity. For example, the Australian 10-year bond rate was (at the time of writing) around 1.81%, and the three-year bond rate 0.096%.
  • Bond price: Goes down as yield goes up. The further out the maturity date, the more exposed the bond price is to movements in yields.
  • The spread: Is the difference in rates between one bond to another. For example, the difference between the US and Australian 10-year rate; or the difference between the two-year rate and the 10-year rate. The credit spread refers to the difference between the government bond rate and a particular state or corporate bond and as such also measures additional risk.
  • Yield curve: Charts out the rates for different maturities. Steep yield curves typically denote a sizable gulf between high long-term rates and relatively low short-term rates.
  • Face value: Reflects the ascribed value of the bond, typically $100 for government bonds, $10,000 for corporate bonds. This also reflects the principal amount lent to the bond issuer which they will repay you when the bond matures.
  • Coupon rate: This is the interest rate paid to you, the bondholder, either quarterly, semi-annually or annually.

Making sense of the current bond market

As you may have noticed, there has recently been a lot of media hype around the rise in bond rates, and the speed at which they’ve gone up. While it may appear complicated, what’s been driving rising bond rates is market optimism over the economic recovery, with the bounce-back from the pandemic now expected to be a lot quicker than previously thought.

What’s also turbocharging that recovery are myriad factors, including the vaccine rollout, government stimulus packages, and a desire by (most) central banks to ensure short-term interest rates remain low. To help stabilise rising confidence amongst borrowers, central banks don’t want to contemplate ratcheting up interest rates until higher inflation is a present reality.

That’s all well and good, but sharper rate rises have served as an inflection point and this is testing the hand of central banks to keep rates low. Given the underlying long-term thesis for rates was built around bonds remaining low – with central banks holding their nerve by keeping their foot on borrowing costs – especially in the short term — all eyes are tentatively watching what will happen next.

Unsurprisingly, the market is constantly on the lookout for any signals that after a decade of deflationary forces responsible for keeping a lid on bond yields, the inflation Genie is finally out of the bottle. While some inflation is good, what central banks want is Goldilocks outcome.

While the right amount of inflation can lead to badly needed higher wage growth, too much inflation is an impost on household debt, erodes wealth, with rising prices for everyday consumables eating away at purchasing power.

Some aggressive bond buying initiated by the Reserve Bank of Australia early last year – which aimed to match the three-year bond rate to the cash rate – reassured the market that cheap money would be around until at least 2024. 

But what we’ve witnessed since the RBA started buying bonds is a rise in bond yields as the market factors-in a higher probability of interest rates going higher. In an attempt to remain true to policy objectives, the RBA recently raised the amount of long-term bonds it is purchasing from $2bn to $4bn. 

Since the beginning of 2021, government bond yields in Australia are again closing in on pre-pandemic levels, which has raised their attractiveness as a safe-haven, income generating investments, with 10-year bond yields expected to nudge 2%.

But while bond markets suggest the inflation Genie is well and truly out of the bottle, the jury’s out on how long it will last. Sceptics argue that too much is being made of any nascent (inflation) signals, especially given the extreme low base from which it’s risen.

While we are arguably in an era of slightly higher structural long-term inflation, the great unknown is where it will go from here.

How to invest in bonds

When it comes to accessing the bond market, investors have several options: 

Individual bonds

There is a vast number of corporate bonds listed on the ASX, which can be traded just as shares are traded. There is also a number of corporate bonds that are not directly listed on the ASX by the issuer, and whereas listed bonds typically have a face value of $100, non-listed bonds may require up to a minium $250,000 investment on issue. However, these bonds can be accessed by smaller investors through ASX-listed instruments called XTBs.

XTBs break such bond issues down into increments of $100. Each has a ticker code beginning with YTM. For example, AGL Energy XTBs have the code YTMAGL.

At the retail level, investors can also buy bonds from a retail bond broker. A broker can inform clients of when there are new bond issues pending, while also providing a buy/sell price in a robust secondary market.

Some bond brokers will also break more expensive corporate bonds into smaller increments, more suitable to retail investors.

Bond Funds

The next best alternative to buying individual bonds is to gain market exposure through bond funds. These investment funds comprise of numerous bonds and possibly other debt instruments.

And many are indeed listed on the ASX.

Bond fund portfolios are designed around specific risk/reward metrics to suit different investors just as stock market funds offer such variations on investor goals. Bond funds are the safer way to play corporate bonds, as most corporate bonds are horribly complicated.

Indeed, the day of the simple corporate bond is over. Pretty much all bonds issued by companies these days are “hybrid” bonds – a mix of debt and an option on conversion into the underlying stock. Bonds can be convertible, converting, redeemable, redeeming…the list goes on, and that’s before we get to “preference shares”, which despite the name are actually a form of debt.

Bond exchange traded funds

ASX-listed bond ETFs are available to anyone with an online share trading account.

The benefit of investing in a bond ETF is the diversification that comes from tracking and replicating the returns from the bond market you choose.

For example, while some bond ETFs track corporate bonds or government bonds, others will offer a much broader universe of bonds and other debt instruments.

The other benefit of bond ETFs is they typically pay out interest monthly, while any capital gains are paid out through an annual dividend.

And as the market in ETFs is provided by the sponsor of that ETF, there will always be a buy/sell price available to investors. Listed bond funds can suffer from illiquidity.

Managed funds

Investing in bonds through managed funds is not unlike buying bond ETFs. Fund managers typically provide a collection of bonds and other securities that directly align with their clients’ appetite for risk.

However, unlike ETFs, managed funds are administered by professional fund managers, who actively try to beat the market, albeit for a higher fee.

Superannuation

Included within most diversified super funds is a defensive interest component which includes an element of bond exposure.

However, there’s nothing to stop you allocating more (or indeed all) of you super balance to a portfolio comprising a selection of bonds (assuming you are eligible to run a self-managed super fund).

It’s not uncommon for retirees to have portfolios heavily skewed towards defensive assets, including a higher proportion of suitably-rated bonds.

FNArena's introduction to understanding bonds series:

This is the second installment in this series aimed at educating and informing investors about the ins and outs, pros and cons, and various intricacies of bonds as an investable asset.

The first installment, Why All This Fuss About Bond Yields, was published on March 31, 2021:

https://www.fnarena.com/index.php/2021/03/31/why-all-this-fuss-over-bond-yields/

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