The media might only have eyes for the stock market, but fixed income is the world’s largest asset class.
It’s worth $169 trillion, making it almost twice the size of the global stock market (McKinsey & Company, 2017)
It’s also a diverse space, with a plethora of different instruments and opportunities jostling for the attention of investors. Fixed income securities include individual bonds, mutual funds and ETFs. The financial industry tends to over complicate things, especially when it comes to fixed income. So, in this introduction to fixed income investing, we’re going to give you the knowledge and tools you need to start investing in the bond market.
Bonds are essentially loans that can be traded. Issuers — either governments or private corporations — borrow money from investors and issue them with bonds in return. This takes place in the primary market, where investors buy and sell huge volumes of bonds every day.
Bond are effectively IOUs that legally commit borrowers to repaying their debts, typically with interest. Retail bonds tend to be issued in clips of £1,000, but smaller and larger denominations are possible. Once issued, bonds are actively bought and sold by financial institutions and individuals in the secondary market.
Bond prices go up and down depending on a range of factors. Investors must weigh the upside potential of a bond going up in value against the downside potential of a bond falling in value. To understand the forces at play, let’s drill into the nuts and bolts of how bonds are structured and how they might perform over time.
Bonds are composed of 2 core elements:
The coupon is the return you get from investing in a bond. It’s the interest rate issuers promise to pay to bondholders until the bond matures. This is expressed as an annual percentage of the bond’s notional value. So, a bond with a 5% coupon will pay £50 for every £1000 of the bond’s principal value, annually. Note that some bonds pay semiannual coupons.
The maturity is the date the bond expires. This is when the face value of the security becomes payable, along with any final coupon payment. It dictates the term of the bond.
Armed with these two inputs, investors can begin to understand the value of bonds by looking at the wider market.
How bonds are priced
To understand how to trade bonds, first, you need to understand how to price them.
Bonds are typically issued with a face value of £1,000 and mature at par, which simply means that at the end of the bond’s term, bondholders receive the face value.
Prices are quoted as a percentage of par, so the par value of a bond with a face value of £1,000 is quoted as 100.00. The market price of a bond is the price quoted by buyers and sellers in the market at any given time. The ask price is the price you can buy at. The bid price is the price you can sell at.
Market prices vary. Let’s say you buy 10 bonds, each with a face value of £1,000, giving a total value of £10,000. If the market price drops to 95.00, your bonds are worth £9,500. If the price rises to 102.00, your bonds are worth £10,200.
Yield is everything
Newcomers to fixed-income investing can get mixed up between coupon and yield. As we know, the coupon is the fixed-rate that the bond pays to investors over the life of the security. It’s a percentage of the bond’s face value.
Yield is what you expect to earn from your investment, expressed as an annual percentage. It takes the purchase price of the bond into account, along with its fixed-rate cash flows and the return of principal at maturity.
The key thing to remember is that bond yields are inversely related to prices. This means that as the price goes up, the yield of the bond goes down. If a bond is priced at 100.00 and it pays an annual coupon on 5%, it has a 5% yield. Because the bond is priced at par and has not gone up or down in price, the coupon matches the yield. But if the price of the bond falls to 95.00, the yield will rise to 5.26%. If the price rises to 105, the yield will fall to 4.76%.
Pay close attention to credit quality
So, price determines its yield. But what drives the price?
The answer is complex — and fascinating — as a number of different factors cause bonds to rise and fall in value. These include underlying interest rates and other macroeconomic indicators, market liquidity, and of course, good old supply and demand. But one driver, in particular, tends to have a big impact on prices. That’s credit risk.
Credit risk is the risk that an issuer will default and fail to pay back the principal of the bond with interest, meaning investors can get their fingers burnt. In December 2001, Argentina defaulted on $93 billion of its external debt. So, it can happen.
Credit ratings, created by ratings agencies such as Standard & Poor’s and Moody’s, measure credit risk. Analysts are assigned to government and corporate issuers and evaluate their creditworthiness. This involves obtaining information from reports, as well as from interviews and discussions with senior management. These inputs are combined with analytical judgement to assess the issuer’s financial condition, operation performance and risk management.
Ratings serve as a guide, helping you to make sensible allocations across a wider portfolio of fixed-income investments. But they should not be taken as gospel. History shows that ratings agencies get things wrong.
Confusingly, different ratings agencies use different scales to denote credit quality. Bonds rated AAA are considered the safest fixed-income investments. Bonds are considered investment grade if their rating is BBB- or higher by Standard & Poor’s, or Baa3 or higher by Moody’s. Bonds rated below these thresholds are known as high yield bonds. As these are riskier than investment-grade issues, investors expect to earn a higher yield to compensate them for the greater risk. For those who know what to look for, this can present fantastic opportunities.
Consider corporate bonds
The corporate bond market is the largest section of the global bond universe after government issued securities. It presents investors with a huge amount of choice.
Keep an eye out for our next post on how to navigate the corporate bond market, where we will dig deep into this fascinating sector and explain how it can deliver big returns for your portfolio.
Please remember that bonds are investments not savings or deposit protected products and your capital and interest is at risk.
As with all investments your capital is at risk.