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Bond knowledge

Deep dive into what bonds are and how they work
Deep dive: What is a bond?
Updated
March 29, 2021

OK, we’ll be frank, this isn’t about all the various James Bonds. It’s about investment bonds. We apologise for the misdirection.

However, in many ways, these bonds are just as exciting and dynamic as James Bond. Certainly the Timothy Dalton years.

Bonds are one of the most important, highly traded and politically significant asset classes. However, they’re also crazy complex. So we think it’s high time for some demystification. Plus we’ll pepper the post with some James Bond stuff too.

What is a bond?

A bond is a tradable debt security: a loan that an investor can choose to make that can also be bought and sold.

Y’know the phrase “my word is my bond”?

That’s the sentiment behind bonds: an IOU in security form.

Bonds are part of a wider class of assets called fixed income, so-called because they’re meant to deliver set, predictable payments.

As you’ll know from our asset class post, both companies and governments can issue bonds.

Roger Moore does

How do bonds work?

Say an institution (e.g. a company, a government) needs a loan to invest in a programme, to pay down another loan or build something impressive.

E.g. the giant sun laser from Die Another Day

It can issue bonds as a way for interested investors to lend that money to them.

Bonds come in dizzying number of variations, including some where the investor agrees to receive less money than they initially lent!

However, these are the common rules for most bonds.

When bonds are bought directly, the purchase price is money lent to the issuer. The bondholder legally owns the debt, which will usually pay out regular interest. The riskier the debt, the higher interest the bond commands.

Bonds also come with a maturity date: this is when the bond expires and the debtor has to pay back the original money lent.

Usually, the longer the initial time-frame of the debt, the higher the interest rate. This is because a longer time-frame brings greater risks, especially the risk of inflation eroding the value of your principal.

The original price of the bond paid back on maturity is the face value of the bond, also known as the par or principal.

So as a standalone instrument, a bond has these fixed qualities:

  • A face value/par value/principal — the value of the loan to be paid back on maturity
  • An interest rate (also known as coupon rate) on the face value — determining the risk of the loan at the time of making it
  • A maturity date — how long until the money gets paid back 💰

Pretty simple, right? 👍

Well, bonds are also tradable. Whoever makes the original loan doesn’t have to keep it. You could sell it through the bond market. And if you’re an investor after bonds, you don’t have to buy new ones directly from debtors, you can buy existing ones from other investors.

All this trading happens in the context of a constant re-evaluation of the debts’ risk levels and trading prices can be very different to the face value of the bonds.

So yep, this is where bonds get ever so slightly more complex. Let’s dive in. 😃

Yield and price

The most common way to value a bond is its yield. There are a few different measures of yield, which include various bits of extra return (e.g. profit on selling your bond), but the simplest and most useful is ‘current yield’.

The current yield is the interest/coupon rate on a bond relative to its current price. Note that this is different to the coupon rate itself.

A super simple example

A £1000 5-year UK government bond that delivers £50 interest each year has a current yield of 5%. However, if the market price of the bond were to drop to £900, the coupon rate is still 5% with £50 of annual interest, but the current yield is now 5.5%.

Bond yields are ultimately determined by the market as an effective judgement of the riskiness of the debtor vs the attractiveness of the investment opportunity.

The yield on newly issued bonds is determined in a sort of auction process between the debtor and big institutional investors. The issuer/debtor sets the amount of debt they want to issue and an interest/coupon rate on that debt. Appraising the risk and opportunity, the institutions bid a price for these new bonds. That purchase price is lent to the issuer.

The price settled in the auction creates an initial current yield which reflects the market opinion on the bonds. Sometimes the purchase price is the same as the face value, so the yield is very close to the actual interest rate.

However, it doesn’t have to be. Bonds with £100 face value could be initially bought for e.g. £98/apiece. In this scenario the issuer will only receive £98 per bond but would still have to pay back £100 when they mature.

You could think of this as a sort of primary market.

Retail investors can usually also purchase government bonds in this primary market, but direct access to corporate bonds is usually restricted to big institutional investors.

In general, most investors don’t buy bonds direct at source — they buy on the huge secondary market.

The yield on these bonds is determined by the prices quoted in the market.

For instance, Spectre fund manager, Ernst Blofeld

The (secondary) bond market

When the interest rate you can get on new bonds rise, the prices of equivalent bonds on the secondary market decline. After all, why buy an old bond when you can get the same investment, the same risk and more interest with a new one?

This is what could have happened with the 5% 5 year UK bond in the super simple example above. If interest rates on new, roughly equivalent bonds rose to 5.5% in the primary market, that would cause the price of that 5% bond to decline so that the current yield was closer to that 5.5%.

Similarly, when interest rates on new bonds go down (which they’ve been doing for a while) the higher rate on old bonds is more attractive and their prices rise to reflect that.

A bond trading over its face value is a premium bond; below its face value it’s a discount bond.

Overall, bonds tend to reach an equilibrium so that yields on the secondary and primary markets offer roughly the same return to price for equivalent assets. A secondary market bond with 5 years remaining will tend to towards the same yield as a new one with 5 years ahead.

However, you also have to factor in the face value of the loan. The closer the loan is to maturity and the fewer interest payments remain, the closer the value of the bond will get to the face value.

This is pretty easy to understand: let’s take that pesky 5-year bond with £1000 face value and 5% interest rate. Its price dropped when new loans started offering better interest.

However, once the bond is very close to maturity (for instance, one day away) there’s no time left to receive more interest. Now, the loan doesn’t have any really have any value beyond the £1000 payback at maturity.

Another nuance is that this isn’t a clean cause and effect where new interest rates in the primary market drive the prices and yields on old bonds. The trading activity and sentiment expressed in the secondary market also has an influence on the auction process of the primary market.

You also plug in the analysis of the big rating agencies, which determine widely respected risk levels for governments and companies.

It’s kind of a huge hodgepodge of financial analysis, investor ambition and calculation on what opportunities already exist.

Plus: “LOUD NOISES”

Note that none of this trading of bonds affects the original loan made to the debtor on the primary market. That loan was already made for a set amount of money at a set interest rate. The face value doesn’t change either: the amount the bond will return on maturity is fixed.

What’s changing is the owner of the loan and the price they pay for it.

The best way to think about it is that if you buy a bond on the primary market, you actually make a loan; on the secondary market, you buy a loan.

Risk of bonds

The first risk of a bond is simply the value fluctuation in the scenarios above. If a better interest rate is available on bonds today, you’ve made a worse deal on a bond you bought yesterday.

The bigger risk on a bond is a default — the debtor not being able to pay either the interest or the money back on maturity.

This risk varies heavily on the category of debtor. Government debt is usually considered less risky than company debt and the more stable the government, the safer the debt. Bonds from highly stable governments (US, UK, Germanty etc) are usually considered the safest defensive investment, but usually offer very modest returns. In fact, in the chaotic years after 2008–2009, some large institutions were even willing to buy negative yield bonds from stable governments (i.e. receiving less money than they lent at the end of the term) simply to keep huge cash piles in a reliable place.

The ratings agencies mentioned above have huge influence on the perceived risk of a particular debtor. This is why it’s a big deal when governments’ credit ratings slip. It’s like being told, “sorry mate, you can’t buy a phone on contract.” 🙈

In worst case scenarios, governments have a last resort solution to paying off their debt: printing more money. Of course, this devalues the currency and causes inflation so in real terms it may not be much better.

“No you can’t have the wheelbarrow”

This option isn’t available to countries that don’t control their currency. For instance, part of the reason that Greek debt was/is considered particularly risky is that as part of the Eurozone, the Greek government don’t have the ability to just print money to pay off debts.

Very risky bonds are classed as junk bonds by rating agencies. A junk-level interest rate is relative to the economic conditions, the timeline of the bond and the type of debt: right now, there could be a yield of only 4% on short term (0–5 year) government debt on quite a high risk junk bond.

However, for some company debt, that yield could be fairly conservative. Don’t worry though, companies also issue junk bonds. The co-working space company WeWork recently issued $700M of debt at an interest rate of 7.8% — with a junk rating.

How we think about bonds at Freetrade

Well, obviously Sean Connery is top, then Brosnan… OK, enough of that.

As a general rule, if you’re investing for the long-term the younger you are, the less you should hold in (government) bonds. These bonds are very safe, but don’t have the same return opportunity as equities/stocks. And when you’re young and have time to ride out market downturns, you want to maximise your return opportunity.

However, bonds are still worth considering as a part of any diversified portfolio. They’re a neat way to safeguard money you don’t want to put into equities while still yielding some investment return. While government bonds aren’t yielding much at the moment, they’re a very secure asset class.

However, as you’ve probably noticed, the bond market is a complex playground, not necessarily easy to navigate for the retail investor.

In fact, the great paradox of bonds is that they’re a traditionally conservative investment encased in a totally byzantine, confusing market.

The seminal Wall Street exposé is about being a bond salesman

That’s why right now we’ve chosen simple exchange traded funds as our access point to bonds as an asset class.

These ETFs buy up bonds to pursue a particular strategy: corporate debt, short-term or long-term UK bonds. They also rebalance their portfolio of bonds to match the performance of the market.

This allows you to have very liquid exposure to bonds without worrying too much about the massive variety of different bond types, calculating yields, worrying about timing and building exactly the right balance.

The ETF does all of that for you. The performance of the fund tracks the general performance of the class of bonds you select.

We now have these fixed income ETFs in our stock universe and we’ll add more and more as we expand.

Popular bond ETFs

  • iShares UK Gilts — UK govt debt
  • iShares UK Gilts 0–5yr — Short-term UK govt debt
  • iShares Indexed Gilts — Inflation-linked UK govt debt
  • HY Corp Bond — High yield company debt
  • HY Corp Bond Hdg — Hedged high yield corporate debt
  • iShares Corp Bond — Investment grade company debt
  • iShares Corp Bond 0–5yr — Short-term company debt
  • iShares Corp Bond ex Fin — Non-financial corp debt
  • iShares Ultrashort — Very short-term debt
  • US Treasury 1–3 year Bond ETF (CU31)
  • US Treasury 3–7 year Bond ETF (CU71)
  • US Treasury 7–10 year Bond ETF (IBTM)
  • Vanguard US Corporate Bond ETF — VUCP
  • iShares High Yield Corporate Bond Hedged — IHHG

And finally, since this question always comes up, UK bonds are called gilts because the paper used to come with fancy gold lining. 🎩

There! You can now dazzle your friends with your knowledge of bonds, whether at the pub or your luxury island lair.

Important Information

This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice.

When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.

Eligibility to invest into an ISA and the value of tax savings depends on personal circumstances and all tax rules may change.

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