Issue: June 2012 / August 2012
Expert Opinion

Bond basics

Ramastwi...crucial understanding
Controversy over Sanral has heightened interest in the bond market. Tsana Ramastwi, a portfolio analyst at Meago Asset Managers, provides a quick guide.

For pension funds, obliged to invest in them, bonds have compelling attractions. They offer guaranteed returns and cater for all risk appetites. They’re also the basic building blocks to determine investment returns in other asset classes, including equities.

How do they work? How are they valued? When to buy or sell?

A bond is a debt security, in which the issuer (e.g. a government, a municipality or a company such as the SA National Roads Agency) owes the holder a debt. Depending on the terms of the bond, the issuer is obliged to pay interest (the coupon) and to repay the principal amount later (the maturity date). It is thus a formal contract to repay borrowed money with interest at fixed intervals.

There are various types of bonds available for investment. Within each broad bond category there are securities with different issuers, credit ratings, coupon rates, maturities, yields and other features. Each different category and each different security offers its own balance of risk and reward.

Bonds, like other securities, have a primary and a secondary market. The primary market is the first issue of the bond; the secondary market comprises trading in the bond at various prices until the maturity date when the principal amount is repaid. The closer to the maturity date, the more the price of the bond will converge on the original issue price.

The issue price of a bond depends on supply and demand. The bond yield reflects the risk; the higher the bond yield, the higher the risk and the higher the return. Because of risk, a bond issued today by the Spanish government would have to offer a higher yield that one issued by the German government.

When a bond is issued, its price is the present value of the future payments (the coupon payments and the principal amount) during the term of the bond (the period up to the maturity date) discounted at the prevailing interest rate. Changes in market interest rates will impact on the price of the bond.

To understand how bonds are priced, take two simple examples. The first is a Retail Savings Bond (called an RSA) issued by the SA government. The second is a bond issued by a smallish company, ABC Ltd. Both are issued in denominations of R100; both have a term of five years. and both carry a 10% coupon.

The two look identical, but obviously aren’t. The stability factor of the SA government is considered higher than that of ABC. Assuming that investors rate the stability factor of the SA government at 100% (which rarely happens, for even bonds issued by the German Bundesbank are discounted), then ABC Ltd would need to offer a discount (called a haircut) of let’s say 50%.

Therefore, the issue price of the RSA is R100 and of the ABC it’s R50.

The yield of a bond is the required rate of return given the risk undertaken by the investor. It’s calculated as the coupon payment divided by the bond price. On their date of issue, the respective yields on the two bonds are:

Yield R10 R10
Interest (Coupon) R100 R50
Issue Price 10% 20%

The issue price (the original principal) and the coupon payment do not change over the term of the bond. So if they don’t change, why does a bond’s quoted value (its price) change?  

If market interest rates increase, the issued yield on a bond will be lower than the current required rate of return and the price of the bond will now fall. Conversely, if market interest rates decrease, the price of the bond will rise.

Another reason that the price of a bond might rise or fall pertains to the stability of the issuer. Say that confidence in the stability of the SA government falls by 20%, on a market estimate, whereas ABC Ltd publishes results that show it is sitting on a R1bn nest egg. Then the market price of RSA bonds might fall by 20% while ABC Ltd bonds might rise by 100%, thus:

Yield R10 R10
Interest (Coupon) R80  R10
Issue Price 12,5% 10%

Miraculously, the RSA yield now exceeds the ABC yield!

But let’s assume that you’re a US pension fund whose rules prescribe that you can only invest in government bonds. At a yield of 12,5%, the RSAs may still look attractive when compared with Spanish and Italian bonds trading at an expensive yield of just below 6%. In other words, you’re using bond prices as a yardstick for determining risk against return.

Using bonds as an investment yardstick

Every listed security has a yield. In the case of shares (equities) it is calculated by dividing earnings per share by the share price (the reverse of the PE ratio).

Let’s say you’re an investment professional who must decide whether to keep your shares in (the fictitious) Bloggs Industries. Its earnings per share are 62,5 cents, while its share price is 500 cents. The yield is thus 12,5%, which is exactly the same as the yield on the RSA bonds in our example.

So, if you’re worried about the share price falling, your safest bet is a switch into more RSAs.