Investor Guide
Investor Guide to Bonds
threadneedle.com
Introduction
Why invest in bonds?
Although your capital is normally considered safe in a traditional deposit account,
low interest rates have eroded the returns from banks and building societies in
recent years, while equity markets have displayed heightened volatility. For these
reasons, bonds have moved increasingly into the spotlight.
There is no doubt that bonds can provide real benefits for a wide range of investors,
but the advantages – and risks – of bond investing are all too often misunderstood.
In this guide, we investigate the bond market and its different sectors, as well as
the risks and rewards associated with various types of bond.
To help your understanding where we refer to specific terms, we have included a
jargon-buster on page 11.
Please read this important information.
You cannot predict future performance by looking at past performance. The value of
investments, and the income from them, can go down as well as up, and you may
not get back what you put in. Threadneedle is unable to provide financial advice and
you should not interpret anything in this guide as advice. If you are unsure about
anything you should speak to a financial adviser. For details of one in your area
please go to www.unbiased.co.uk.
The material in this brochure is for information purposes only and is not intended as
an offer or solicitation with respect to the purchase or sale of any security.
Investor Guide to Bonds
What is a bond?
A bond is basically an IOU issued by a government, quasigovernment body or a company. When you buy a bond you are
effectively lending the issuer money for an agreed amount of time
and at an agreed rate of interest. Both of these factors will be
specified in the name of a bond when it is issued.
In return for the loan, the issuer agrees to pay you a fixed amount on a regular basis. This
payment is called the ‘coupon’, and is effectively the interest on the loan. Crucially, the issuer
also agrees to pay you back your original loan in full at the end of the agreed term. So, bond
investors get a regular and pre-agreed stream of payments for a fixed time period, then have
the original sum invested returned to them at the end of the period.
Issuer
An ‘issuer’ is a company, government or quasi-government body that wishes to borrow
money to fund its future plans.
Coupon
The ‘coupon’ is the amount of money paid each year as interest by the bond issuer to the
investor.
Principal
The borrower issues a bond to the investor in exchange for a sum of money known as the
‘principal’.
How a bond works
To illustrate how a bond works, a fictional bond issued by Widget Company is shown below.
If you buy this bond, you effectively agree to lend Widget Company £100 for a period of five
years. Throughout this period, Widget Company will pay you a ‘coupon’ of £5 per year, and at
the end of the period they will also return your original investment of £100.
Widget Company
We promise to pay the holder on
31 December 2015
the sum of £100
Meanwhile, you will get:
£5 on 31 December 2011
£5 on 31 December 2012
£5 on 31 December 2013
£5 on 31 December 2014
£5 on 31 December 2015
Illustrative example
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Investor Guide to Bonds
Why bond prices change
The most important difference between a bond and a normal IOU is that bonds can be
bought and sold on the stock exchange. If bonds were not tradeable in this way, then bond
prices would remain completely stable, but investors would have to wait some years to
get their capital back.
However, because bonds are tradeable, you can sell your bonds at any time. And, just like
cars, houses or anything else that can be bought and sold, the price you get will depend
on how much you want to sell them, and how badly others want to buy them. Because
these factors depend in turn on the ever-changing investment climate, bond prices are
constantly fluctuating.
Prices and yields
You often hear the word ‘yield’ used when describing bonds. The yield is a measure of the
return available from a bond, given the agreed coupon, the time left to redemption and the
current price. In other words, it is a way of measuring the attractiveness of an individual
bond. Because bonds are not always held to redemption, there are different methods of
calculating the yield.
‘Running yield’
This measures the return if you bought the bond today but did not hold it to redemption.
Going back to our example, imagine that after four years the Widget Company bond price
is standing at £99. The coupon remains unchanged at £5 – this never changes, since it was
agreed at the outset. In this case, the running yield is 5 ÷ £99 = 5.05%. Conversely, if the
price was £101, the running yield would be 5 ÷ 101 = 4.95%.
‘Redemption yield’
This is similar to the running yield, but assumes that you will hold the bond to redemption
(maturity).
To use the same examples again, if after four years the price of the bond was £99, you
would get your £5 coupon in the fifth year plus £100 back on the redemption date i.e. £1
over the price you paid. So the redemption yield is (5+1) ÷ 99 = 6.06%. However, if the
price was £101, you would get your £5 coupon in the fifth year but would effectively lose
£1 because even though you paid £101 for the bond, you would only get £100 back on
redemption at the end of the year. So the redemption yield in this case would be (5-1) ÷
101 = 3.96%.
Redemption date
The redemption date is when the original sum is repaid to the investor, and coupon
payments cease. It is also known as the maturity date.
Yield facts
nn
Prices and yields move in opposite directions. In other words, when prices rise, yields
fall and vice versa.
nn
Different yield calculations can provide quite varied results. You should always take care
to clarify which type of yield is being quoted.
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Investor Guide to Bonds
Risks and rewards of holding bonds
Although we have seen that bond prices do fluctuate as market
conditions change, these fluctuations are generally much smaller
than changes in the prices of some other investments, such as
equities. The main benefit of holding bonds is the regular coupon
payments they provide. Traditionally, this combination of more
stable prices and regular payments has made bonds an attractive
choice for income-seeking investors.
The risks involved in bond investing fall broadly into two camps: interest rate risk and
credit (or default) risk.
lnterest rate risk
Imagine again your Widget Company bond that we introduced on page 3, paying a coupon
of 5% per annum. If bank deposit rates rose to 7%, you would be able to get a better
return by keeping your money in the bank than from your bond. So you would seek to sell
your bond. The trouble is, so would everybody else. The result is that the price of bonds
with coupons of 5% would fall. Conversely, if deposit rates fell to 1%, your bond would
represent a very attractive investment, and the price would rise.
Inflation has a similar effect, particularly on bonds where the loan is over a longer period.
Indeed, inflation is the enemy of bond investors. If inflation rises, the purchasing power of
your coupons far into the future falls, so the bond becomes less attractive and the price
falls. However if inflation falls, your future coupons are likely to be worth more in real
terms, so your bond becomes more attractive and the price rises.
Bond Bond
prices prices
Interest Interest
rates/inflation
rates/inflation
Bond Bond
prices prices
Interest Interest
rates/inflation
rates/inflation
5
Investor Guide to Bonds
Credit or default risk
This is the risk of the issuer going under and being unable to pay coupons or repay the
original sum invested at redemption. The likelihood of this happening varies from one issuer
to another, and from one day to the next according to economic and business conditions.
For instance, the UK government issues bonds, which are often referred to as ‘gilts’
(originally the certificates were gilt-edged hence the name). It is accepted that the UK
government is extremely unlikely to default on its bond payments, and so gilts carry very low
default risk. Companies, however, could run into financial difficulties, and so bonds issued by
companies (called ‘corporate bonds’) carry higher default risk.
Different factors influence gilt yields of varying maturities. For example, yields on short dated
bonds (up to five years to maturity) are mostly influenced by movements in official interest
rates (base rates), whereas at the long end of the spectrum (gilts with a residual maturity of
over 15 years), expectations for economic growth and inflation are key considerations.
Within the corporate bond market, detailed analysis is carried out into the financial strength
(or ‘creditworthiness’) of individual companies, and bonds are rated according to the
likelihood of default. To take an example, a large, established pharmaceutical company
operates in a sector where profits tend to be fairy insulated from the economic cycle. As
such, it is deemed less likely to default than a newer company operating in a more risky area.
The economic outlook, the rise and fall of different industries and the competitive position
of companies within those industries are just some of the factors that can affect the longterm ability of an issuer to repay its debts. This is why credit ratings of individual companies
change over time, and why investing in bonds requires constant in-depth analysis. Of course,
past performance is not a guide to future returns. The value of investments and any income
from them may fall as well as rise and you may not get back the original investment.
In the event of a company bankruptcy there is a hierarchy which details the order in which
investors are paid out from the assets of the firm. In this situation, bond investors are treated
as preferential creditors compared to equity holders although it should be remembered that
bond holders are not paid out first in the event of a company going bankrupt.
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Investor Guide to Bonds
A range of investment opportunities
The different levels of risk result in a spectrum of bond coupon
levels. For example, it is only natural that investors should demand
a premium for the extra risk they are taking on when lending money
to a less well established company. Therefore, bonds issued by
these firms typically have higher coupons than those issued by
well financed blue chip companies – hence the term “high yield” is
often applied to higher risk corporate bonds.
Different types of issuers are affected in different ways as events unfold in the market.
For example, changes in interest rates have a greater effect on government bonds, while
changes in the economy and corporate profitability have a greater effect on corporate
bonds.
Like any marketplace, the bond market does have inefficiencies, and sometimes these
inefficiencies mean that the excess returns available from one bond or sector more than
outweigh any extra risk involved.
These opportunities are difficult for private investors to discern on their own. But by
carefully researching bond issuers and weighing all of the economic and technical factors,
professional bond fund managers aim to construct portfolios of bonds that are ideally
suited to investment conditions.
This is why many bond investors prefer to access the bond market via investment funds.
Risk/return ready reckoner
Type of bond
Main influences
Risk level
Yield level
Government
Interest rates
Low
Low
Investment grade
Interest rates /
Corporate news flow
Moderate
Medium
High yield
Corporate news flow /
Company finances
High
High
Investment grade and high yield (speculative grade) bonds
Relatively well financed companies’ bonds are referred to as ‘investment grade’, while bonds
issued by less secure companies are known as ‘high yield’. Investment grade bonds can be
rated AAA (the most creditworthy with the lowest yield) through to BBB, while high yield
bonds can be rated BB or lower. These are the ratings defined by Standard & Poor’s (S&P),
one of the foremost credit rating agencies, and are shown below alongside the classifications
from Moody’s, another leading credit rating agency. Rating agencies can change their views
on the issuer’s creditworthiness, which can lead to ratings upgrades or downgrades, with
corresponding positive or negative implications for the company’s bond prices.
Investment Grade
Speculative Grade
S&P
Moody’s
Description
AAA
Aaa
Highest credit quality
AA
Aa
Very high credit quality
A
A
High credit quality
BBB
Baa
Good credit quality
BB
Ba
Lowest degree of speculation
B
B
Speculative
CCC
Caa
Speculative
CC
Ca
Highly Speculative
C
C
High default risk
D
D
Default
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Investor Guide to Bonds
Yield curves and spreads
Yields for the same type of bond but with different redemption
(maturity) dates can be depicted graphically. For instance, the
prevailing yields on 5, 10 and 15 year UK government bonds may be
plotted on a chart. A yield curve essentially plots current bond yields
against their time to redemption, enabling investors to compare the
yields of short, medium and long dated securities at any given time.
“Normal” yield curve
Yield %
1 year
Maturity
30 years
This is significant as yield curves change over time and fund managers seek to analyse where
the best value is (i.e. when is it the best time to purchase a bond taking account of its correct
price, its yield and its maturity date).
A normal yield curve, as shown above, will show higher yields for longer-dated bonds than for
short dated issues.
By plotting the yield curves of different types of bonds on a single chart it is possible for a
fund manager to assess their relative attractiveness. Yields will reflect the riskiness of the
bond investment and consequently corporate bonds offer a higher yield than government
securities. The difference between the two is known as the spread. The spread can widen or
contract depending on a range of factors such as the prospects for the economy and inflation
(fundamentals) and the demand/supply outlook (technicals) for the bonds.
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Investor Guide to Bonds
Bond yields also reflect the riskiness of the investment
As with any investment, the higher the potential risk, the higher the potential reward and
investing in bonds follows the same thinking. For example, a bond issued by a government
such as the UK is seen as a very safe investment as the UK is very unlikely to default on its
obligations. Therefore to attract investors, the UK government does not need to offer a very
high rate of interest rate whereas a corporation issuing a bond is seen as a higher risk and
therefore has to issue bonds paying a higher rate of interest to attract investors. The chart
below illustrates the different yield curves of two illustrative examples for a government bond
and a bond issued by a company.
The yield curve and bond spreads
Corporates
Yield
Spread
Government Yield Curve
Maturity
The term ‘spread’ refers to the amount of extra yield that is earned for holding bonds with
more risk than government debt. Using the example above, the spread illustrated as the
different in yield between the Government Issue and the Company Issue.
Duration
Managers of bond portfolios pay close attention to duration. This is an approximation of the
sensitivity of the price of a bond to changes in yield. Maturity is the main driver of duration
although there are also other relevant factors.
Quoted in years, duration indicates the average exposure to market risk and allows bonds
with different coupons and maturities to be compared.
Bonds with a longer duration tend to react more to changes in interest rates than those with a
shorter duration, and therefore bond fund managers actively manage duration to reflect their
views on the path of interest rates.
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Investor Guide to Bonds
Summary
As we have shown in this guide, the bond market is very varied
and offers a wide variety of risk and return combinations, as
well as behaving differently to equities and other asset classes.
Consequently, we believe that bonds have an important role to
play in a diversified portfolio.
In the same way that equity fund managers would look to gain an in-depth knowledge
of a company, its market and whether it is valued correctly by the market, bond fund
managers also undertake an equally in-depth analysis around each bond held within a
portfolio. Talented fund managers are able to consider all of these moving parts and use
their experience and judgement to make high conviction calls on which investments offer
the best potential for their clients.
At Threadneedle our highly regarded team works together, debating and challenging
consensus views to ensure that our best investment ideas are leveraged across portfolios.
This approach has delivered excellent long-term performance, and we are confident that
our clients will continue to benefit from this expertise in the future. As always with any
type of investment, please be aware that past performance is not a guide to future returns
and that you may not get back your original investment. Threadneedle is unable to provide
investment advice so if you are unsure whether an investment is suitable for you, you
should contact a financial adviser. For details on one in your area visit
www.unbiased.co.uk.
10
Investor Guide to Bonds
Jargon-buster
Coupon – the amount of money paid each year as interest by the bond issuer to the
investor
Credit rating – the independent rating given to an issuer’s bonds. They run from the
highest rating AAA through to the lowest D – the higher the rating, the lower the risk of
default.
Default – if a bond issuer cannot afford to pay the coupon or principal at maturity.
Duration – This is an approximation of the sensitivity of the price of a bond to changes in
yield.
Investment grade – the bonds issued by relatively well financed companies.
High yield – the bonds issued by less secure companies.
Issuer – a company, government or quasi-government body that wishes to borrow money
which they do by issuing a bond.
Maturity date – see redemption date.
Principal – the amount paid by the investor to buy the bond originally.
Redemption date – the date when the original sum (the ‘principal’) is repaid to the
investor and the coupon payments cease. Also known as the maturity date.
Redemption yield – also known as yield to redemption, maturity yield and yield to
maturity. This yield takes account of the bonds coupon divided by the current market
price of the bond but also allows for the change in capital value for the set period until
redemption i.e. the total return on the security express as an annual yield.
Running yield – also known as current yield, interest yield, earnings yield and flat yield.
This is the coupon payments of a bond divided by its current market price. It is one
of the most commonly used forms of yield expression but it takes no account of the
compounding effect of income reinvestment.
Spreads – The difference between the two bonds respective yield curves.
Yield curve – A graph that plots current bond yields against their time to redemption.
11
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visit threadneedle.co.uk or speak to your
financial adviser.
Important information The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may
not get back the amount invested. The research and analysis included in this document has been produced by Threadneedle Investments for its own investment management activities, may have been
acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice. Information obtained from
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Office: 60 St Mary Axe, London EC3A 8JQ. Authorised and regulated in the UK by the Financial Services Authority. Threadneedle Investments is a brand name and both the Threadneedle Investments name
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