Issue: Oct 2010/Jan 2011
Back to Basics 3

Understand bonds

Stephen Peirce

Peirce...an A, B, C

They comprise a big slice of retirement funds’ portfolios, but few trustees really know much about how they work. Stephen Peirce, fixed-interest portfolio manager at Coronation, reveals all.

Those not closely involved in the financial markets could be forgiven for not being overly familiar with the workings of the bond markets. After all, media tend to concentrate on movements in the stock market or on the value of our houses. Few people probably question how government funds its spending in the event of a shortfall in tax receipts, or who lends to the banks so they can onlend to individuals and businesses.

It may then come as a surprise to learn that globally the bond markets dwarf equity markets in both scale and levels of turnover. At end 2009 the global bond market was estimated at $82 trillion with an average daily turnover of $822 billion.

A bond in its simplest form is an IOU whereby one party (the investor) lends an amount to a borrower (a government, bank or a corporate). In return, the investor receives a series of predefined interim payments (coupons which are akin to dividends) and the return of the original principal (often referred to as ‘par’).

The price an investor would be willing to pay for this series of future payments is equal to the ‘present value’ of these cash flows. This present value is calculated by using the average yield to maturity (YTM) on the bond.

The expression above allows us to compute the price of a bond if we know the yield to maturity, or the yield to maturity if we know the price of a bond. What we can demonstrate is that a bond’s price is inversely related to its yield to maturity.

Bond Price/Yield relationship

Price     YTM%
105.35 = 7.55 + 7.12 + 6.72 + 83.96 6
102.62 = 7.48 + 6.99 + 6.53 + 81.63 7
100.00 = 7.41 + 6.86 + 6.35 + 79.38 8
97.47 = 7.34 + 6.73 + 6.18 + 77.22 8
95.03 = 7.27 + 6.61 + 6.01 + 75.13 10

Plotting the results of our analysis (see Figure 1) reveals that the price/yield relationship is almost linear. What we can also see is that a longer-dated bond is more sensitive to changes in yields.

Cash flows for a 3-year bond

Price = Coupon in Year 1 + Coupon in Year 2 + Coupon in Year 3 + Redemption Payment in Year 3
    (1+1)1   (1+1)2   (1+1)3   (1+1)3

The movement in a bond’s price for any given movement in market interest rates can be seen as a measure of a bond’s riskiness. Bond investors refer to this measure of risk as ‘duration’, where longer- dated bonds typically have a higher duration. If a bond’s duration is 5, then a 1% movement in rates would typically lead to approximately a 5% movement in the value of the underlying bond price.

Duration (usually expressed in years) can be defined as the weighted average maturity of a bond’s cash flows, where the present values of the cash flows serve as the weights. In the case of a 10-year bond the duration is 7, 25 years. Figure 1 shows that a move from an 8% yield to a 6% yield gives rise to a price rise of close to the 14, 5% (7, 25 x 2) implied by the duration. Where a portfolio manager holds a range of different bonds, an average portfolio duration can be calculated.

When looking to invest, portfolio managers will have to select from a wide range of bonds. In assimilating this information, the return on a bond will often be plotted against the maturity or riskiness of the bond (duration). A line of best fit would then be applied - commonly referred to as the ‘yield curve’ as illustrated in Figure 2.

Changes in the Reserve Bank’s repo rate and the market’s expectations for longer-term interest rates will alter the slope of the yield curve. In the same way, investors can extract information from the yield curve as to the market’s expectations for future interest rates. Correctly forecasting how the yield curve will move goes to the heart of a fixed-income fund manager’s job and ability to deliver superior returns.

  • So far we have discussed fixed-rate bonds and assumed that we will receive back all of our future cash flows. In essence, we have looked at instruments akin to conventional government bonds.

However, many other forms of bonds exist. Whatever form the bond takes, and however unusual its structure and entitlements, all are outlined in the initial prospectus. It enables; the investor to do the necessary value analysis.

Let’s consider two other common types of bonds:
In the case of floating rate bonds, the coupon values change periodically in line with a specified reference rate, usually a three-month interbank rate (jibar). Because the coupons track the movements in short-dated interest rates more closely, they have a much lower interest-rate sensitivity (duration) and offer protection in times of rising interest rates.

Portfolio managers may elect to invest in these bonds when they are concerned that the bond market is not fully pricing in the risks of rising interest rates, or when a portfolio needs to more closely track the movements in shorter-dated interest rates (e.g. in a money market fund).

With an inflation-linked bond, both its coupons and final redemption proceeds increase in line with inflation. The yields quoted on inflation-linked bonds are real yields and represent the return obtainable after inflation. These bonds are particularly useful investments for retirement funds where the benefits to members often accrue in line with inflation.

In considering whether an inflation-linked bond is attractively priced, investors should consider the breakeven rate of inflation. This is the rate of inflation that would make the total return on the inflation-linked bond equal to the return obtainable from a fixed-rate bond with a similar maturity. Should investors think inflation is likely to be higher than implied by the breakeven rate, they would favour inflation-linked bonds.

Critical to consider when making a loan (invest in a bond) is not only the structure of the borrower’s future cash flows but the likelihood that these payments will be honoured. As a result, the credit worthiness of the borrower influences the interest rate at which investors are willing to lend. Government bonds are considered the least risky and should trade at the lowest yields, but  they are not risk-free as investors in Greece are finding out.

Loans to companies and banks are more uncertain, so investors demand an additional premium over and above the yield on an equivalent government bond. This is the ‘credit spread’. The greater the perceived risk or maturity of the loan, the higher the required spread. If the credit spread on a bond narrows, the bond will increase in value and fall should it widen. Portfolio managers can supplement the returns on their portfolios by holding more non-government debt. However, this is not risk free.

Bonds play an important role in providing returns for retirement funds. The ability to forecast  future payments offers an element of certainty that can be incorporated into a retirement fund’s future payments.