Understanding the basics of bonds

Bonds are a type of loan set over a fixed period. Investors lend money to a bond issuer and in return they will receive regular interest payments until the bond matures, when they will receive full repayment of their capital.

Bonds are issued at a particular face value, with a ‘coupon’ or interest rate. The coupon is usually fixed from the time the bond is issued through to its maturity. For example, a 5-year government bond with $100 face value and a 5% coupon will pay investors $5 a year in interest payments per $100 of principal invested over 5 years, the duration of the bond. At the end of the loan, the bond issuer will pay the lender the final $5 plus repay the total amount of capital, $100.

A secondary bond market exists which allows bond holders to buy and sell bonds before maturity. It is in this secondary market that bond prices are set. In this market, interest rate movements can erode the value of a security, or the price at which it is traded. This is true of all bonds which have coupons that are fixed for the duration, whether they are Australian government bonds, corporate bonds, global bonds or high yield bonds.

Factors affecting a bond’s price

The most important factor affecting a bond’s market price is the level of interest rates. When interest rates fall, existing fixed rate bonds of all types become more valuable as they continue paying out the same coupon even though interest rates have fallen.

On the other hand, if interest rates rise, fixed rate bonds become less valuable because their coupons are static and they therefore trade at a ‘discount’. The chart below shows this relationship.

Duration measures a bond price’s sensitivity to interest rate changes. The longer the duration of a bond, the more the bond’s price will move when interest rates change. This is called duration risk. For example, if the duration of a bond is 4, that means that with a 1% rate rise, the value of the bond would fall ~4%. But if the duration is 1, then the bond’s value would only fall by ~1% if rates rose 1%.

This hypothetical illustration does not represent the return on any particular investment.
By moving the lever on the diagram below, you can see the impact of a change in interest rates depending on the duration of a bond.
_{Source: VanEck. For illustrative purposes only.}

Along with an individual bond, any bond fund or bond exchange traded fund (ETF) will have a particular level of duration. The weighted average duration can be calculated for an entire bond portfolio, based on the duration of all individual bonds in the portfolio.

Taking bets on rate movements

By choosing a bond or bond fund of particular duration, investors can manage the interest rate risk of their bond investment.

Active bond fund managers claim they can add value by finding investment opportunities that either capture yield or mitigate duration risk. Where an active fund manager sits on duration will depend on their view of interest rates.

If, for example, an active manager thinks interest rates will go up, the manager will shorten the duration of their portfolio to reduce duration risk. But if the manager thinks rates will fall, they will lengthen duration. Investors can easily check a bond fund’s duration by checking with the fund manager.

Some fund managers who expect short-term interest rates to increase, for example, will position their funds to increase holdings of short dated bonds and floating rate notes (FRN). That’s because a key characteristic of FRNs is that the coupon, instead of being fixed as it is for regular bonds, is variable or ‘floating,’ calculated as a set margin above a recognised short-term market interest rate.

A FRN’s coupon is generally reset every 3 months, so FRNs have low duration risk. If rates rise, therefore, the price impact on a bond fund largely holding FRNs would be minimal.

For example, the coupon on FRNs is often stated as “the 3-month bank bill swap rate + 1%” or “3mth BBSW + 1%”. This means FRN coupon payments will increase if rates rise and vice versa.

Longer duration bond funds, in contrast, typically own a mix of longer dated bonds and fixed income securities that mature from one to ten or more years. Duration risk here is greater as the bond’s price will move relatively more when rates change compared to shorter duration bonds.

Many professionally managed bond funds are currently sitting on short duration strategies because they are concerned about rising interest rates, being led by the US Federal Reserve unwinding the historical low level of interest rates in recent years.

Benefit of bonds

Despite omnipresent duration risk, bonds are relatively defensive investments. Compared to equities, bond prices aren’t as volatile and income payments can’t be stopped while the issuer is solvent, unlike dividends, which any company can cut at any time.

Bonds may do well when the economy slows down, interest rates are falling¹or equity markets sell off as investors turn to bonds, especially government bonds, as safe haven assets. As a result, bond prices often move in the opposite direction to equities. This may cause bonds to cushion a share market sell-off, as they did during the GFC when bonds rallied while shares dived.

Good quality fixed-rate corporate bonds have at times provided comparable, and in some cases, better returns compared to Australian and international shares. Over 10 years to 30 June 2018, the return on corporate bonds outstripped the return on the S&P/ASX 200 Accumulation Index, which returned 6.40% per annum. Over the same period, corporate bonds, as measured by the Bloomberg AusBond Credit 0+ Yr Index, gained 6.65% per annum, as the chart below shows.
 

_{Source: Bloomberg, as at 30 June, 2018.}

The graph below shows the strong outperformance of Australian bonds during the GFC compared to equities. Corporate bonds easily outperformed Australian equities during the GFC in 2008 and again in 2011 which was marked by high levels of equity market volatility.

_{Source Morningstar Direct, You cannot invest in an index. Past performance is not a reliable indicator of future performance.}

During the GFC, bonds did a lot better than Australian equities, which took almost six years to recover. Bonds withstood the assault and came out post the GFC performing much better. 

So bonds have an important role to play in investors’ portfolios as they may help to protect against a correction in share markets. Also, where there is a prospect of rising interest rates, an investment in a bond fund with a short duration may be more appealing than investment in a longer dated fund.

Investors should speak to their financial adviser or stockbroker and read the relevant product disclosure statement before investing in any fund.

_{IMPORTANT NOTICE: This is general information only and not financial advice. It does not take into account any person’s individual objectives, financial situation or needs. Before making an investment decision in relation to any fund, you should read the PDS and with the assistance of a financial adviser consider if it is appropriate for your circumstances. VanEck’s PDSs are available at www.vaneck.com.au or by calling 1300 68 38 37. All investments are subject to risk, including possible loss of capital invested. Past performance is not a reliable indicator of future performance. No member of the VanEck group of companies gives any guarantee or assurance as to the repayment of capital, the payment of income, the performance, or any particular rate of return from any fund.}

_{¹http://www.sr-sv.com/the-correlation-of-equity-and-bond-returns/}