In the second of a three-part series, Peter Alcaraz, author of The Wealth Game, explains the key considerations when assessing a bond.
When you invest in a bond, you are lending money to the bond issuer, generally for a specified time period. In return, the issuer is legally obliged to pay interest, or coupon, at a pre-agreed rate and to repay the original amount borrowed, principal, face value, nominal value, or par value on the repayment date (maturity).
Bonds are a financial instrument for funding government or corporate issuers. They are also known as fixed-income securities. As a bondholder, you are a creditor of the issuer.
A bond is a productive depreciator because its capital return is fixed and therefore erodes with inflation, but it generates an income.
Unlike company dividends that are not certain as to quantity and are not guaranteed, bond interest is certain but only as strong as the issuer, which may range from a well-funded country to a risky or near-bankrupt company.
You can hold a bond to maturity or sell it in the secondary market if there is one at the price on the day. This determines your capital repayment. People sometimes assume that the capital invested in bonds is safe but forget that the price of bonds falls when investors seek higher yields.
Unless you hold a bond until maturity, the capital repayment is at risk, and only by holding an individual bond directly can you keep control of this. Bonds held in managed funds are bought and sold at the discretion of the manager.
Publicly traded bonds are evaluated, risk assessed, and rated by one or more specialist agencies, like Standard and Poor's, Fitch, or Moody's. The higher the rating, the less risky the bond is deemed to be and the lower the interest demanded by investors, so it's cheaper for the issuer.
In comparing bonds, investors look at 'redemption yield' or 'yield to maturity' (YTM). This takes into account any difference between the purchase price you pay and the par value of the bond.
If you spend £130 in the market to buy a £100 bond that pays £5 per annum with five years to run, you will receive income of £5 per annum but only £100 at redemption. Your capital loss of £30 works out as £6 per annum for each of the remaining five years. Take this as a percentage of the price you paid, so £6 / 130 × 100 = 4.6%. This figure is deducted from the 5% running yield to produce a YTM of only 0.4% per annum!
Bond prices tend to move in the opposite direction to interest rates. If interest rates rise, the fixed coupon attached to a bond becomes less attractive, and the price falls until it delivers an acceptable yield. When interest rates are low, and investors are chasing income, they will bid up the price of bonds, as they accept lower yields.
Inflation erodes the income and capital from bonds, making them less valuable. If inflation is 3% per annum, the real running yield on a 5% bond is 2% per annum. If inflation rises to 4% per annum, the real yield drops to 1% per annum. To compensate, the bond price falls, and its nominal yield rises. If investors want a 2% real return, but inflation is running at 4%, the nominal return needs to be 6%.
Falling and low inflation are associated with rising bond prices partly for this reason and also because low inflation usually means low interest rates. Rising or high inflation is consistent with falling bond prices, exacerbated by the interest rate rises that usually accompany it.
Peter Alcaraz read law and economics at Durham University and spent 24 years advising small and mid-sized companies on mergers, acquisitions, IPO's and fund raisings, first as a lawyer and for the last 20 years in corporate finance. At the age of 46 after reaching 'O' he left city life to write, study, travel and spend more time with his wife and two daughters.
His first book, The Wealth Game: An Ordinary Person's Companion was published in 2016 and has become a staple among wealth managers, business schools and private individuals wishing to develop their personal finance skills.
- A version of this article originally appeared on our sister website interactive investor. Peter Alcaraz is a freelance contributor and not a direct employee of interactive investor.