How to… Understand fixed income and its jargon
By Darius McDermott
With an increasing amount spoken about bond yields and spreads, what does it all mean?
Stockmarkets get all the attention. It’s FTSE 100 this, Dow Jones that… They are far more exciting than boring old bond markets – and far less complicated. From negative yields to credit spreads and short duration to par value, the language alone can be a lot to get your head around. With this in mind, we thought we would try to tackle some of the jargon and get back to basics.
A bond is basically a loan. Just as you or I would go to a bank to get a loan to buy a house or maybe a car, companies and governments also borrow money.
In the UK, government bonds (also known as gilts) are widely viewed as one of the safest types of bond from a default perspective: they are backed by the UK government, which has never defaulted on its payments.
But in return for this safety, investors can expect a lower yield than they receive from other types of bond. It should also be noted, however, that because the yield is lower, government bonds tend to be sensitive to interest rates. A basic example would be if a bond had a ‘duration’ of five years and interest rates increased 1 per cent, then the bond’s price would drop by approximately 5 per cent.
In other countries, especially emerging markets, government-issued bonds aren’t necessarily deemed to be so safe. This means yields are usually much higher, as the risks are too. Another important aspect when it comes to emerging market bonds is that they come in two types: local currency (which is a country’s own currency) and hard currency (which is in US dollars). Sometimes you want emerging market exposure, but you do not want the currency risk – the result is that you just buy the US dollar bond.
The other type of bonds are corporate bonds. Businesses look to drum up capital for several reasons and, depending on the firm’s credit-worthiness or its ‘rating’, it will have to compensate investors for the extra risk with a higher yield too.
A bond is rated by credit rating agencies like Standard and Poor’s and Moody’s. The bonds most likely to deliver on their promises are rated AAA. Anything from this level down to BBB is classified as investment grade and is seen to be lower risk. Bonds given a B and BB rating are classified as high yield with a higher risk of default.
With tens of thousands of bonds, all in different currencies, offered over various periods, some secured, some unsecured and some simply unrated, it can be an overwhelming job for an investor or adviser to even contemplate doing the research and selection themselves.
It’s perhaps because of this complexity that strategic bond funds have become so popular over the past decade. They allow investors the opportunity of delegating not only the stock picking, but also the asset allocation, to professional investors. These funds are fully flexible, investing across the fixed income spectrum and the managers can shift allocations as they see fit.
An example and some jargon-busting
Corporate Bond One has decided to raise capital by issuing a 10-year sterling bond with a fixed annual coupon of 4 per cent at a price of £100. The par value of the bond is £100. The offer period is between 1-15 December 2019. An equivalent 10-year government bond trades with a yield of 3 per cent.
Offer period A new bond will be open for applications for a fixed time known as the offer period.
Maturity Simply the lifetime of the bond (in this case 10 years). For fixed rate bonds, the longer its length the greater its sensitivity to changes in interest rates.
Coupon The amount the bondholder receives over a set period until the bond matures. Note this is not the same as the yield on the bond, which will depend on the bond’s price. In this case bond holders receive £4 annually.
Par value The face value of the bond. In this case £100 at maturity.
Credit spreads You will often see corporate bond spreads mentioned in relation to an equivalent government bond – essentially, they have the same maturity but different credit quality. In the example above, the spread between the equivalent government bond is 1 per cent.
What are the benefits of being a bondholder in a company compared to a shareholder in its equity?
Bonds can be a great complement to equities. As a peer recently described them, they are the dependable twin, the one that keeps the other grounded and ensures you don’t lose your shirt when markets go sour.
Should a firm default, there is an order of who has a claim over the assets and who gets repaid first. In this pyramid, bond holders sit above equity holders in the pecking order – meaning they are more likely to get their money back.
Some 35 years into a bond bull market, it is hard to find much value in the fixed income market.
But on a bond-by-bond basis, there are a number of opportunities to be found – both long-term and tactical: perhaps another reason why strategic bond funds are seen as the go-to-sector in this space today.
Darius McDermott is managing director of FundCalibre