Exposure to domestic and international sharemarkets through equity funds may occupy a big slice of your investment portfolio, but bond funds can play their part by increasing portfolio diversification and balancing out the ups and downs of equity fund performance. Here's a brief overview of how bond funds operate and what they invest in. Later in the week we’ll be looking at how to measure bond fund performance, asset allocation within a diversified portfolio, and many other fixed income-related topics.
How Bonds Work
When you buy a share, what you're effectively buying is part of the company that issued that share and a right to some of that company's profits in the form of dividends. Bonds, on the other hand, are more like lending money to a company or institution. You receive a regular income stream in the form of interest payments. The size of these payments is determined by a number called the "coupon rate", which, in most cases, is fixed. The remainder of the return comes from the repayment of the original investment, known as the "principal", at the end of the life of the bond, which is known as the "maturity date".
The issuers of bonds realise they must compensate you for two things: the surrender of your money to the company or government until a future date; and the effect of inflation – the loss in purchasing power the investment will have sustained over the life of the bond. So, in addition to repaying the principal at maturity, bond issuers also pay regular interest payments based on the coupon rate. The coupon rate specifies the rate of interest to be paid every year, or half-year, depending on the type of bond, and this is fixed in almost all cases. (We're keeping this discussion at a relatively simple level, but there are other types of debt securities, among them "zero coupon" and "inflation-linked" bonds, but they're a story for another time.)
These coupon interest payments are designed to compensate you for the fact that, for example, £1,000 loaned out in the form of a five-year bond in 2005 will not buy as much in real (after-inflation) terms at maturity in 2010. Because prices rise over time, you as an investor need to make sure that you get not only your initial £1,000 back, but also enough extra to compensate for the effects of inflation. If inflation is running at 2.5%, an investor seeking a return of 4.5% on their investment needs a bond with a coupon rate of 7%.
Another key concept in bond investing is the sensitivity of the bond's price to changes in interest rates. If a bond is more sensitive to interest rate changes, or has a long “duration”, then small changes to interest rates generally lead to large changes in price. Conversely, if a bond has a short duration, changes to interest rates usually have a relatively smaller effect on the bond's price. Duration itself is determined primarily by the time to maturity, but also by the size of the coupon.
Bonds can be grouped broadly into two groups: government bonds, otherwise known as gilts; and corporate bonds, issued by companies to help fund their business activities or expansion. Most bond funds will hold a mixture of both, with different interest rates and different maturity dates, which therefore reduces the risk to your capital but means they cannot promise a fixed return; instead they aim for a 'target return'.
Price/Yield Relationship
Bond prices tend to move in the opposite direction of interest rates. The price of a bond represents the value to the bondholder of the income stream – the value of the regular interest payments.
When interest rates rise, the rate bondholders get from their investments becomes lower than the rate available from other investments, making the bond less attractive, and therefore causing the price to fall. Similarly, when interest rates fall, the price of a bond will generally rise, because the existing coupon rate investors get from their bonds will be higher than the market interest rate, making bonds more attractive to buyers, and therefore raising the price.
Once investors have bought a bond, they can either hold it and receive the regular coupon income payments and the repayment of the principal at maturity, or they can trade it on the market. By trading, they may receive either more or less than the face value of the bond, depending on market conditions. The current market price is determined by what's called the “yield to maturity”, or a measure of what the market is willing to pay for the bond. The yield to maturity indicates the price the investor is willing to pay today in return for receiving money later in the form of the regular coupon rate payments and the principal at maturity.
Price and yield have an inverse relationship. If bond prices fall, yields rise, and if prices rise, yields fall. Take for example a bond with a yield to maturity running at 7%. If this rises next week to 10%, the bond price falls, and the investor is paying less for the same string of future cashflows (the regular coupon rate payments). If the yield to maturity falls from 7% to 5%, the bond becomes more expensive – the price goes up – because the investor is paying more money to receive the same payments.
Riskier Than You Might Think
Bond funds are often seen by investors as low-risk investments and on the whole, compared with shares, they are. It's important, though, to understand the kinds of risks which come with bonds, and not to see them as a risk-free asset. One of the fundamental risks attached to a bond – and therefore to the managed funds which invest in them – is that the issuer of the bond will either fail to make the regular income payments, or to repay the principal (the amount of money you initially invested) at maturity. This is known as “default”.
Different bond issuers come with varying likelihoods of defaulting on either paying their coupon rate, or repaying principal at maturity. Government bonds, especially from developed countries, are generally regarded as having a very low risk of this happening because they are less likely to go broke, and have ultimate revenue-raising powers to fund their debt obligations.
This isn't always the case though, as we saw recently with speculation that the parlous state of the Greek economy would lead the country to default on its debt obligations. (There continues to be speculation about Portugal and Spain.) Several other countries have actually defaulted on their debts over the past 20 years, among them Argentina and Russia.
The credit quality of bonds is assessed and updated regularly by credit ratings agencies such as Standard and Poor's and Moody's. These agencies rank bonds on the financial strength of the issuer, and the likelihood of default. In this ranking system, bonds are ranked from AAA down to D. Bonds ranked below BB+ are known as “sub-investment grade”, meaning that in the credit rating agency's opinion, they are more likely to default on their obligations to holders of their debt securities. (You may sometimes also hear these kinds of bonds described as “junk”.)
These credit ratings affect a country or company's ability to borrow. Investors are happy to lend money to governments and well-established companies which appear likely to repay their debts. But companies without a track record or which have poor credit ratings have to work harder to attract investors' money to their bonds. And this perception of creditworthiness influences the rate of interest that these countries and companies have to pay. Because, rationally, an investor would rather put their hard-earned savings in the most secure place possible, bond issuers with lower credit ratings have to offer higher levels of return to entice investors.
For example, if the government is paying a 4% return on its bonds, then companies that are “investment grade” may have to pay 5.5%, while issuers of “sub-investment grade” bonds may have to pay 7.5%. They have to pay a higher rate of interest to compensate investors for their higher potential risk of default.
When looking at bond funds for your portfolio, it's important to pay careful attention to the kinds of debt securities in which the funds invest, and to find out as much as you can about them.
The fund's category will give you some guidance, but you should also read our analyst research reports and documentation from the fund manager carefully. Bond funds which have seductive labels such as “high yield” do offer the potential for higher rates of return, but as we saw during the global financial crisis, do so by investing in debt securities that have higher risks of default or losing a significant amount of their value.
This is an edited version of an article that first appeared on Morningstar.com.au, a sister site of Morningstar.co.uk.
