The Attributes of Bonds: 10 June 2011
How bonds work and how they can benefit investors
As part of our diversified approach to investments Chartwell Direct provides access to over 2,000 funds. These include combinations of shares and bonds i.e. bond funds, as opposed to individual bonds. It's always useful to understand the elements that make up any investment strategy and this article looks at the general attributes of bonds as an asset class.
The right bond should offer security of principal (initial investment) and income; transparency, liquidity and a high degree of predictability. Unlike equities they can sometimes seem opaque. After all, owning a share in a company is exactly that. You own part of the company. So what does it mean to own a bond, or invest in a bond fund?
A bond is basically a loan from the investor to the issuer, be they a government, company or other entity. Whilst that may sound risky, they actually rank further up the capital structure than equities. Companies are required to pay back their debts, including bonds, before lesser ranked capital. For equity holders, whilst owning part of the company, there is no schedule of repayment as there is with bonds. For the issuing entity this should mean relatively cheaper funding as there is more certainty for the lender. For the investor this should provide added security. Should a company go bankrupt, bond holders have priority over equity holders to get paid.
There are, of course, a myriad of different types of bonds and it is important, as well as choosing the right issuers in the right proportions, to choose the right bonds, or bond funds. For instance "junk bonds" are considered to have a significantly higher risk of default than their investment grade counterparts, and can exhibit volatility more akin to equities.
Safety of capital is not the only consideration. Bond prices will fluctuate even if there is no question over the issuers' ability to pay. This is because, at its simplest, a bond is a series of cash flows. Investors receive periodic interest payments, or coupons, typically once (or twice) a year. At maturity the principal sum is repaid, plus the final interest payment. These payments are fixed for the life of the bond, hence the term ‘fixed interest' is commonly used to describe the asset class. So if these payments are fixed, why should the price of the bond change?
If you have money but are willing to put off using it for a while, someone else will be willing to pay you for that use. Interest is the reward for delaying consumption. Thus we can say money has a time value - the longer you are prepared to put your money away for, the more you should expect to get paid.
If we were to invest £1,000 today for a year at 1%, we would receive £1,010 in a year's time. This effect is more powerful the longer the period and the higher the rate. £1,000 today is worth £1,104 in ten years time, even at a rate of just 1%. Of course, the rate will also depend on who is borrowing the money and how much money is involved.
Then there's the yield of a bond. What will our initial £1,000 return us over the life of our bond? We can calculate this, in today's money, discounting each cash flow for the interest rate and period. The yield to maturity will then tell us our total return on holding the bond until we receive our money back. This is quite different to just simply looking at the coupon of the bond over its life, as yield takes account of both the current price as well as the current value of the income and principal to be repaid. For example, a bond maturing in 2019 with a 5½% coupon at its current price has a yield to maturity of 4¼%, reflecting the current market structure of interest rates. Of course, it should be possible to realise the investment before then but yield is, at its very least, a way to compare and thus begin evaluating the return on different bonds.
So why do bond prices move? If interest rates change, or are expected to change, then the value today of all the bond's cash flows today will also change. Duration, although the maths involved is mildly fiendish, is simply the weighted average life of all these discounted cash flows, and allows us to calculate that change in price. For instance, the above cited bond maturing in more than 8½ years has a duration of closer to 6½ years. Knowing that, it is possible to work out the expected change in value. As yields fall, everything else being equal, prices will rise. The corollary happens when yields rise.
Theory is all very well, but what does this mean for investors? Well, a truly cost-effective way of managing a portfolio is through the use of investment funds. A fund is a collection of different underlying assets (typically shares or bonds) and a number of holdings (companies) so it is already a mini portfolio of its own.
At Chartwell Direct we research hundreds of funds each year to ensure we advocate only those that we have full confidence in, for our clients. We then go a step further to simplify the investment process by offering four expertly blended portfolios to suit the four main types of investment strategies. Click through to read more on these.