Bond Basics - Part 2

Bond Basics - Part 1 
Isaac explains how bonds work and who would want to buy bonds.

Bond Basics - Part 2 
Isaac explains the risks associated with investing in fixed income.

Bond Basics – Part 3 
Isaac explains bond pricing. 

Video Transcript:

Alanna Petroff: Welcome to the second installment of Bond Basics. I'm joined by Gareth Isaac from Schroders. He manages GBP 1.5 billion in different bond funds, so he certainly knows what he's talking about when it comes to fixed income and bonds. Today we're going to be talking about risk.

Hi, Gareth.

Gareth Isaac: Hi.

Petroff: Okay. So, let's go over risk. What are the risks involved with buying a bond?

Isaac: Okay. Well, obviously, there are risks involved with buying any financial instrument and bonds are no exception to that. There are three main types of risk. The first one is credit or default risk, and that's the risk that – A, you don't get your coupon, your interest back, when the company or the government tell you they'll give it you; and B is that they don't give you the money back at the end of it, so those risks are quite important.

The other one is interest rate risk, and this goes to the pricing issue of bonds that, if you own a bond which has a certain yield on it, and a certain rate of return that you're hoping for, but interest rates in the market rise significantly then the return that you're expecting isn't quite as good. So, the price of your bond falls.

Petroff: So, what you are going to be making – you know what you're going to be making in terms of the interest rate, but other interest rates around you are better.

Isaac: Sure.

Petroff: So you're making less money than everyone else around you, I suppose. Is that what you're saying?

Isaac: Yeah. Sure. I mean, if for example, you buy a bond and interest rates are 5%. You're expecting to get 5%, and then the prevailing rate in the market rises to 7%. Obviously, your bond isn't as attractive as the new ones being issued at 7%, so the price of that will fall. So, we refer to that as interest rate risk.

Petroff: Okay.

Isaac: And the final main risk in the financial markets is liquidity risk, and this is something which is more prevalent now than it has been maybe before. That is the risk that, if you'd like to sell your bond in the secondary market, you're just not able to do so.

Petroff: No one wants to buy your bond?

Isaac: Well, in times of panic that we've seen fairly recently is that when you're looking to sell a bond into the market, and there is no appetite for anybody to buy that, you suffer significant liquidity risk, and if you're a forced seller that can be quite painful.

Petroff: Okay. So, now let's go through, in terms of risk, let's talk about some issuers that would be safe, and some that would be more risky, and let's go through some examples.

Isaac: Okay. Well, safe is quite a subjective term again…

Petroff: Yes.

Isaac: …to use. I mean, safer is probably the best.

Petroff: Okay, safer.

Isaac: So, if you're looking for a safer bet, you're probably looking at something like the UK government. You know, the UK government has a very strong track record of paying back its coupons…

Petroff: Good.

Isaac: … which is helpful for all those investors. So, you would say that is quite a safe investment, and yields generally reflect that, they tend to be lot lower than you'd get in the corporate bond market. An example…

Petroff: So, you're getting less bang for your buck, but you know you're getting that money back.

Isaac: Sure. I mean, that's the idea. So, obviously, you end up having to pay for that surety or the expected surety that you're going to get that money back, and that by having to do that you have to get lower yields.

Petroff: Okay.

Isaac: If you're looking for high yields in the market. You can invest in maybe a high yield company, which doesn't have a particularly good long track record, or doesn’t have a long history of trading, but they're looking to expand quickly. Now you'd get a better return on those investments, but obviously, you'd be taking a higher degree of risk that they wouldn't pay back their coupons, or they'd expand too far. Their cash flow would dry up, and maybe they default on the whole loan.

Petroff: So, let's say it's a new technology company, with this new application that everyone loves, but the company itself is rather new and so you're worried that maybe it's a fad, maybe they won't be able to pay back their debts, that would be…

Isaac: Yes. Similar to that, absolutely. I mean, if you look at the corporate bond market. If you look at big companies, the oil companies, or big pharmaceuticals or the retailers, which have a long and consistent track record. Obviously, the yield on those are going to be a lot lower than they would in these start-ups that don't have a particularly long track record.

Petroff: Okay. But those companies will still have higher yields than government bonds?

Isaac: Yes. I mean, you'd expect that, and that we refer to that as a spread between the corporate bond and the government bond, and spreads are generally quite wide relative to where governments are trading.

Petroff: Thanks, Gareth.

Isaac: You're welcome.

Petroff: That was Gareth Isaac, he's from Schroders, and I'm Alanna Petroff. Thanks for joining us on Morningstar.co.uk. 

This video was originally published on Morningstar.co.uk in May 2012.