If you were asked to guess how much the global bonds market was worth… what would you put it at? A few hundred billion? Well, the answer is closer to a staggering $200 trillion!1 It’s no wonder we field so many questions about bonds. So, what are bonds? How do bonds work? And what role should bonds play in your portfolio?
We put a panel of wealth relationship managers and advisers to the test. Here are their answers to customers’ 10 most-asked questions about bonds.
1. What are bonds?
Think of a bond as an IOU. When you buy a bond, you’re effectively loaning money to an organisation for a certain length of time. It’s a debt-based investment. At the end of the agreed fixed period, the bond will mature and repay the initial capital. In addition, along the way the borrower will pay interest to you.
2. What are the different types of bonds?
There are a number of variations, but the following are the largest categories.
Corporate bonds are issued by individual companies to finance their activities and investments.
Government bonds are issued by countries to fund public spending.
3. How do bonds work?
To help you understand how bonds work, it’s important to understand what price, coupon, yield and value all mean.
The price is pretty self-explanatory. It’s what it costs you to buy the bond. The price of the bond will rise and fall over its ‘lifetime.’ It’s affected by all sorts of factors, including supply and demand, how close the bond is to maturity and credit quality as well as more macro influences like inflation, taxes and wages. Critically, bond prices are affected by interest rates. When interest rates increase, bond prices come down and vice versa. A bit like a seesaw.
The coupon is what the borrower pays you while you own the bond. It doesn't go up and down which is why bonds are referred to as a fixed-income asset class.
The yield goes up and down over the bond’s lifetime because it represents the relationship between the fixed coupon and the variable price of the bond (which goes up and down). This income is paid out at intervals, for example quarterly or annually.
The value of the bond is what you’ll receive when you sell it. If you sell it at maturity, you’ll get the same amount that you paid for it (the borrower is simply settling its IOU). If you want to sell the bond before it matures, its value (the price someone else will pay for it) is worked out by a mix of the value of the debt to be repaid, the interest it pays each year, the number of years until maturity and how risky the debt is.
4. What is the maturity of a bond and why does it matter?
Some bonds are short-dated and mature within five years, typically one to three years. As these carry less inflation and default risk, they usually receive lower interest (or yield/income). And some are long-dated bonds, more often used by governments, and mature upwards of ten years. These tend to receive higher interest.
Of course, there are no guarantees and sometimes the interest on short-dated bonds can be higher than on longer-dated bonds. This tends to happen when central banks are increasing interest rates aggressively and can be an indication of an economic slowdown or recession ahead. This situation is known as an ‘inverted yield curve’.
5. Do all bonds carry the same risk rating?
Generally speaking, bonds sit on the lower end of the risk/reward spectrum. However, not all bonds are the same. In fact, each bond carries its own bond rating. There are several global rating agencies which assess the credit worthiness of a company or government.
6. Why should I hold bonds in my portfolio?
In performance terms, bonds may not have the rockstar appeal that equities - shares - might have. And yet, they do play a critical role in a diversified portfolio.
That’s because typically bonds and equities perform differently in the same economic conditions (note the use of the word ‘typically’ because that wasn’t the case in 2022, when they both had a bad year). So, they aim to balance each other.
7. Bonds and equities both fell in 2022. Could it happen again?
There's no doubt it's been a bumpy journey for bond investors of late. However, as with all investment decisions, it's important to look forward and understand how changing market conditions may impact asset class returns.
So, still want to learn more about why bonds are an important pillar within a diversified portfolio? Our Global Cross Asset Specialist, Lukasz de Pourbaix, unpack why in this latest perspective.
Source: 1 - The Times - 21 November 2023
