Understanding how bonds work
The simple bond definition is a form of debt - the investor loans money to the issuer. But there’s much more to how bonds work, characteristics of bonds and different categories of bonds as well as how they respond to economic and market factors
IN A FEW WORDS
Bond definition How bonds work Characteristics of bonds Categories of bonds
4 min reading
Bonds can help to form part of a diverse portfolio, with different categories of bonds offering different opportunities for investors. For example:
- Government bonds (or gilts) – issued by governments to raise funds. Potential income can vary depending on the economic stability of the country issuing the bond.
Corporate bonds – issued by large companies wishing to borrow money.
- High yield corporate bonds offer a higher income in line with the increased risk of not repaying the debt.
- Investment grade corporate bonds are issued by more creditworthy companies and so tend to pay less income.
- Green bonds – can be either government or corporate but have an exclusively environmental focus.
Here we look at how bonds work, take a closer look at these categories of bonds and where opportunities may lie.
Characteristics of bonds
A simple bond definition is a form of debt – a company or government borrows a specific amount of money and promises to pay it back at a certain point. Those who buy bonds will receive regular interest payments (known as a coupon) and then their money back after the agreed term, when the bond ‘matures’.
The level of coupon largely depends on prevailing interest rates and the likelihood of default - the chance that investors won’t get their money back at maturity. This has created a problem for bond investors in recent years when interest rates have been so low that the income available has dwindled to near-zero.
There are different categories of bonds to consider
The main difference is between government bonds, known as gilts in the UK, and corporate bonds, which are issued by large companies wishing to borrow money. However, there is a good deal of variation within each of these.
How government bonds work
Government bonds vary according to the type of issuers (those borrowing money). Governments issue debt to pay for everything from their Coronavirus response to infrastructure projects. Developed market governments – the UK, US, Germany, Canada and so on - are generally seen as a good bet for repayment, but this means investors don’t get much of an uplift over interest rates. The UK 10-year gilt, for example, currently yields around 0.8% per year. That’s not a lot for tying your capital up for a decade.
Investors can potentially get a higher income by looking at the government bonds of emerging countries – Brazil, China, South Africa or Indonesia, for example. Interest rates are often higher in these countries, plus investors get a higher coupon to reflect the higher risk of default. The Brazilian 10-year bond yield is currently sitting at around 9.4%.
Characteristics of corporate bonds
These are issued by corporations around the world to fund investment projects, roll-over existing debt or fund development projects. The coupon depends on the creditworthiness of the institution. Large, well-financed companies (think Unilever, Nestle or GlaxoSmithKline) will generally pay a lower coupon to their investors. These are referred to as ‘investment grade’ companies.
At the opposite end are ‘high yield’ companies. These are borrowers forced to pay a higher income to their bondholders because they are at higher risk of not repaying their debts. They may have a lot of historic debt, or be in a difficult sector, such as high street retail. Investors need to decide whether the higher income compensates them sufficiently for the higher risk.
Introducing green bonds
Green bonds are relatively new. They first came to market in 2007 but have taken off in recent years as the sustainability agenda has gathered pace: the Climate Bond Initiative reports that issuance has risen by an average of 60% per year since 2015, with the cumulative debt in the market rising from $104bn to over $1trn today. (link for compliance Are green bonds the route to sustainable fixed income? - Expert Investor (expertinvestoreurope.com) No follow) Green bonds work in the same way as normal bonds and can be issued by governments or corporations, but are used exclusively to finance environmental projects, covering areas such as renewable energy, energy efficiency and green buildings, pollution reduction, clean transportation, sustainable water and sustainable agriculture.
How the secondary bond market works
While some investors will simply buy a bond when it is issued and hold it for five, 10 or 20 years until it matures at the end of its term, others will look to buy and sell on the secondary market. This is where bonds are traded during their term. Prices are based on factors including the payment due at maturity, the coupon level, the current value of the bond and the amount of the term remaining.
Characteristics of bond pricing
Bond pricing is affected by expectations around interest rates and inflation. In general, inflation is bad for bonds because it makes their fixed income stream less valuable. Usually, the lower the coupon, the greater the sensitivity to interest rates (so government bonds and investment grade corporate bonds are most sensitive). Equally, longer-dated bonds tend to be more sensitive to changes in interest rate expectations.
Higher yielding bonds tend to move more in line with news on the issuer or broader expectations of defaults in the wider economy. In tough economic conditions, default expectations rise and investors often demand a higher coupon for investing in riskier businesses.
Opportunities for investors
Yields are currently low, disrupting the traditional role of bonds as a source of stable income and long-term capital growth in a portfolio. However, it is possible to take positions based on inflation expectations and/or interest rate changes. It may also be possible to trade effectively around the bonds of specific companies if you spot pricing anomalies – are markets suggesting too high a risk of default, for example?
Alternatively, you can leave it to the experts: a strategic or global bond fund gives investment managers freedom to take positions in bond markets across the globe. The Fineco trading platform offers a range of options for potential bond investors, with all the tools you need and clear, fair pricing.
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