JUNO INVESTING ©

The Name is Bond

JUNO INVESTING ©
The Name is Bond

 

The editorial below reflects the views of the editorial contributor only and content may be out of date. This article is sourced from a previous JUNO issue. JUNO’s content comes from sources that it considers accurate, but we do not guarantee that the content is accurate. Charts are visually indicative only. JUNO does not contain financial advice as defined by the Financial Advisers Act 2008. Consult a suitably qualified financial adviser before making investment decisions.

SUMMER 2016

By Caroline Ritchie

So, what are bonds? Simply put, a bond is a debt. When you own a bond, you’re lending money to the organisation that ‘issued’ it – that is, offered the bond to investors. 

Think of a bond as a formal IOU. The borrowing organisation (the issuer) has an obligation to pay you (the holder) back the debt, plus interest, to compensate you for the risk and the period of time it has had access to your money. 

Bonds come in many shapes and forms and may or may not be listed. Around 100 bonds are listed in New Zealand, and these trade on the NZDX, the New Zealand Stock Exchange Debt Market. The main issuers are banks, public companies, local authorities (councils), and the government. You’ll also see bonds referred to as ‘fixed interest’, or ‘fixed interest securities’.

Bonds are always used to raise money, though the reasons and cause may vary. Mostly they’re used to fund growing operations, or repay existing, more expensive debt. 

Occasionally bonds are philanthropic. For example, Kiwi Earthquake Bonds can be purchased from the government for a fixed term of four years, with an interest rate of 2.25 per cent. Since you’ll currently get a four-year term deposit at any bank for 3.45 per cent, the investment is not financially attractive. But the bonds provide New Zealanders with an opportunity to ‘do their bit’ for the Christchurch rebuild. 

How listed bonds work

Think of a bond as a package. A conventional package has markers attached to it to help identify it in the mail system. A bond has various key features – maturity date, coupon rate, and yield to maturity – that distinguish it in the debt market. 

Key features of a bond

•    The maturity date is when the bond expires, and it tells you how long the debt has to run. 

•    The coupon rate is the annual rate of interest the issuer will pay the holder over the life of the bond. Coupon payments are made half-yearly or quarterly. 

•    The yield is the ACTUAL rate an investor receives if they buy the bond on the market and hold it until maturity. Now, here is where things get interesting! 

Yield and coupon rate are different, because the price of a bond changes when it is traded on the market. But the coupon rate never varies. The example in the box at the end of this article explains this in more detail.

Credit ratings and maturity dates

Like any kind of loan, bonds can be gold-plated, highly suspect, or anything in between.

Some bonds carry a credit rating, which is an independent view on the level of risk involved. Higher-rated, safer bonds usually pay less interest than lower-rated or non-rated securities. 

Different bonds offer investors varying options at maturity date. Some bonds may roll over onto floating interest rates at maturity, and others may convert to shares. Alternatively, an issuer may make an early ‘call’ and buy back the debt early. And a few listed bonds have ‘perpetual’ maturity dates. Your local authorised financial adviser will be able to explain all of these in more detail. 

What bonds offer investors

Portfolio managers include bonds in the mix for two main reasons: capital retention and income generation. 

Capital retention

Capital retention is another way of saying ‘investments that do not vary in price a lot’. A good-quality collection of bonds will be low risk. It will not change much in overall value and will provide a steady buffer against the fluctuations of shares within the portfolio. A very low-risk portfolio might have
70 per cent of its assets in bonds. Or, if the investor’s risk profile is aggressive, there could be no bonds, or just a small allocation, say 10 per cent.

Income generation

Bonds – especially New Zealand bonds over the past 15 years – have been wonderful payers of interest. The gap between the interest on bonds and what you can receive at the bank is now narrowing worldwide, as interest rates decrease. But bonds are still used to provide streams of cash into a portfolio (or into your bank account if you’re retired). 

The outlook for bonds and interest rates

Negative-yield bonds are already a fact of life for investors in Europe. So how does that work in practice, and what does it mean for investors?

For example, in Germany a one-year government bond carries an interest rate of minus 0.5 per cent. You put in €1000, and after one year you receive €995 back. 

This looks crazy on the outside, but people are investing in negative yields for a reason. Primarily, this is a ‘flight to safety’ way of thinking about the future. Investors will take a minus 0.5 per cent return now in bonds, over a potential minus 10 per cent loss later in shares, for example. Losing a little is better than losing a lot in highly uncertain market times.

Keep calm and carry on

So will Kiwis have to pay to hold our money in the bank? My knee-jerk reaction, and perhaps yours, will be, “I sure hope not”. We have become used to the flavour of our cash in New Zealand. 

For many years, we have led the developed world with our high interest rates. But it’s easy to look across at Sweden and Switzerland and become scared of what might happen in New Zealand. 

The brighter news is that nothing in economics, just as in nature, ever happens in isolation. These ultra-low rates have not caused Europe to disappear under the sea just yet. Worrying about it never works (with money, anyway), so I suggest that we don’t. 

For now, keep calm, enjoy our comparatively good bond rates, and carry on investing!

 

Coupon and yield in a nutshell

The coupon versus yield part of bonds can be confusing, so let’s take a closer look. 

Company X issues new, one-year Y-Bonds at NZ$100 each, with a coupon of 5 per cent, paid half-yearly. 

Scenario 1

You buy this new bond freshly issued from company X for NZ$100. If you hold it for one year, you will receive two coupon payments of 2.5 per cent (NZ$2.50), plus your original $100 back on maturity. Your overall yield to maturity will be 5 per cent. 

Scenario 2

Say you could not get hold of any Y-Bonds when they first came out and you had to wait to buy them on the market. Y-Bonds list on the NZDX and prove to be popular. People are willing to pay more than NZ$100 for them, because they think they are good quality and they like the rate. 

The bond now trades at NZ$102. You will still receive two coupons of NZ$2.50 each, over the course of one year. But you have paid NZ$102 for them, not NZ$100, which is what you receive at maturity. So your overall yield will be less, in this case around 3 per cent (rounded). 

The see-saw theory

Bond pricing can and does get complicated and that is what your adviser and their calculator and spreadsheets are for. However, just visualise listed bonds as being on a seesaw. On one end is the yield to maturity, which is what you’re really looking for as a bond investor. On the other end is market price. As price goes up, yield goes down: as price goes down, yield goes up. This will hold true for all listed bonds.