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Wednesday, 18 March 2009

Dear Auntie, Why Are My Bonds Bubbling?

Bonds should be Boring Beasts

There are many reasons why your bonds might be exhibiting unusual levels of excitement, but normally they only respond to two things - changes in peoples’ perception of creditworthiness or changes in interest rates. You don’t say which species you’ve got but my guess is these are government bonds, currently flavour of the month. As government bonds are boring beasts, apt to spend much time snoozing in the sun, only occasionally rousing to move around a little, Auntie feels that this calls for an explanation.

Roughly, there are two species of bonds: those issued by governments and those issued by corporations. They both pay a fixed amount of money – interest – to their holders each year for a specified number of years before they are redeemed at “par” where “par” is the price they were issued at. So if you buy a bond and own it until it’s redeemed – to “maturity” – then you know exactly what your return on it’ll be. So a bond is a debt that pays interest and eventually is repaid.

Bonds and Interest Rates

Bonds are mostly issued at round number of currency units so the calculations are easy. For instance, the (imaginary) US Treasury 8% 2019 bond is a government bond paying 8% a year on its $100 issuance price (that’s $8 a year for each bond) until 2019 when it would be redeemed at $100. The interest rate on a bond is always a bit higher than the current national interest rate, to encourage people to buy it, so this would probably have been around 6% when this bond was issued.

Although the amount of interest on your bond is the same every year the price of it’ll vary depending on, as previously mentioned, investors’ concerns over the creditworthiness of the bond issuer and general interest rates. General interest rates are set by governments or central banks and if, say, they reduce the general interest rate by 1% you would roughly expect the interest rates paid by bonds to also decrease by 1% (that’s a rule of thumb, though: bond prices respond to buying and selling and the different between national interest rates and bond yields varies over time).

Bond Yields

As a bond pays exactly the same amount of interest every year for the interest rate on the bond to decrease the price of the bond must increase. So, if the interest rate is changed from 6% to 5% then the price of the bond quoted above at 8% will, roughly, change to pay out 1% less – 7%, technically known as the ‘nominal yield’. As the bond still pays out $8 per year then the price must rise to ($8/7% =) $114.28.

What’s more tricky is the “yield to maturity” which takes into account the interest you get every year plus the bond redemption price. Taking this same example if you buy the bond at $114.28 in 2009 you’ll receive $8 every year for ten years – a total of $80. However, you’ll then receive $100 from the government when it buys back the debt. So you’ll get a total of $180 if you hold the bond to maturity. This is also known as the discount rate.

Note that the closer you get to the maturity date the closer nominal yield will move to the maturity yield because it's increasingly certain that's what you'll receive. It’s a bit more difficult to calculate the yield to maturity than the nominal yield but you can look up in the newspapers or use a bond yield calculator (googling will find you loads). Whatever it is you know it with nearly 100% certainty for the best government bonds.

Misbehaving Bonds

Sometimes bonds get a bit skittish and their prices don’t move with interest rates. In fact sometimes the little beasts do exactly the opposite. This’ll usually be because investors are worried about whether the bond issuer will be able to afford to pay the interest due. If they can’t then they are said to have “defaulted” on the bonds.

Most government bonds are less risky and more creditworthy than corporate bonds if for no other reason than governments can ultimately print money to pay the interest. However, this isn’t always possible and plenty of countries have defaulted on their bonds – Russia in 1998 being the last major example when oil prices crashed and caused its revenues to collapse.

Usually the reaction to this by investors is to stick the country in the naughty corner until it promises not to do it again. It’s unlikely any major industrialised nation would ever default so the debt of the United States, France, Germany, United Kingdom, etc is the most valuable, least risky and most expensive.

Corporate Bonds are riskier than Government Bonds

Corporate bonds are cheaper than government bonds (where “cheaper” means more interest) because companies are more likely to default. Also, corporate bonds are considered safer than shares in the same company because they’ve precedence over shares when it comes to any assets of the company – if the company goes bust bondholders rank ahead of shareholders in the pecking order for anything that’s left over (but may be behind other debt holders of different kinds).

One downside of bonds is that their total return in nominal terms is fixed when they’re bought, unlike shares in a company that have no fixed return. Although shareholders lose everything if a company goes bust they also “share” in the earnings of the company for as long as the company exists.

Banks, Bonds and Bankruptcy

Financial institutions like banks are among the largest issuers of corporate bonds. Unfortunately many banks are also now on the naughty step because they stupidly lent all their money to poor people, with no jobs, who bought big houses at outrageous prices and then went bankrupt. Investors are worried that these losses mean the banks may default on their bond payments.

Currently, then, there’s a big gap between the prices of the bonds of industrialised nations and those of large corporations. Governments have cut interest rates to stimulate lending which has dried up because the silly banks have no money and this has caused a steep reduction in yields on government bonds. At the same time investors have become very scared about the prospects for many companies and have shied away from investing in corporate bonds and shares which has meant that they have tended to put even more money in government bonds, driving up their price still further.

Beware Bubbling Bonds

So if your bonds are bubbling it’s likely that they’re government bonds, issued by a major industrial nation, and that they’re enjoying the so-called “flight to quality”. Unfortunately this doesn’t mean they’re a good investment right now. This is because risk and return are linked and expensive bonds aren’t likely to produce high rates of future return. In fact it’s quite likely that, on some medium term timescale that not even Auntie can guess at, they’ll be very poor investments from the current level, when many government interest rates are hovering around 0%.

Mass issuance of bonds by governments to pay for banking bail outs may also lead to an increase in inflation and bonds do very badly in an inflationary environment because their yields and total returns are fixed (the yield to maturity). If you’ve a bond paying a fixed amount every year and inflation rises rapidly the real value of your investment will be destroyed. Inflation linked government bonds, paying out a variable interest rate linked to the rate of inflation, do exist but these tend to be expensive. It’s also noticeable that those tricky governments aren’t issuing many of these, usually a sure indication that they’re concerned about inflation going forward.

Little scamps, aren’t they?

Balance Your Portfolio

Auntie would always recommend people to have some proportion of their investments in low-cost government bond funds. The wisdom of this approach has been shown over the last few years when they’ve been a good bulwark against the trials and tribulations of the stockmarket. At the current levels, though, they’re unusually risky investments and prudent investors might consider a small rebalancing of their portfolios away from government debt towards high quality corporate debt or broad based passive equity investment to be the safest option at the moment.

Love and Best Wishes, Auntie.

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