Bonds are a fixed income instrument which involves an issuer (usually a government or a business) owing an investor a set amount of money which is repayable at an agreed date. Although equities are often the most thought of investment, the global bond market is worth over $100 trillion (60% of this being government debt) compared to the global equity market of around $65 trillion.
Bonds have a face value which is the amount repaid at maturity, at the date agreed when the issuer repays the investor. Bonds are bought at the market price which can be above the face value (at a premium) or below the face value (at a discount) depending on market outlooks. Bonds also pay coupons at agreed intervals which may be annual or semi-annual. The term coupon rate is the coupon payment amount divided by the coupon’s face value.
Investing in bonds, like all other financial securities, comes with risks. The default risk of a bond is the risk that the bond issuer cannot repay the loan and therefore the bond defaults. Credit ratings done by credit rating agencies such as Moody’s, Standard and Poor’s, and Fitch help investors know the likelihood of their bonds defaulting. Therefore, bonds with a lower credit rating are traded at a cheaper price than those with a higher credit rating. Bonds can also be categorised into different types of asset classes. High-yield bonds pay higher coupon rates as they are deemed more likely to default. On the other hand, investment-grade bonds are those which have high credit ratings and are deemed safer investments as they are less likely to default.
The interest rate risk of a bond, which is generally higher in longer-dated bonds, occurs when interest rates decline fixed coupon rates on existing bonds begin to look more attractive to investors due to the higher returns they offer. This is also true for the opposite. If interest rates are rising, existing bonds may look less attractive as they are offering relatively lower returns in comparison to interest rates which therefore reduces demand and resultantly the market price of the bond drops.
Inflation erodes the purchasing power of money over time. Therefore, investing in bonds does come with an inflation risk which plays a major part in the valuation of a bond. Like the interest rate risk, bonds with a longer time to maturity are more sensitive to inflation. When inflation is predicted to be high, bond prices usually trade at a discount, as the future payments become less valuable. However, if inflation is predicted to be at a low rate, there is a more positive outlook on bond investments as the purchasing power of future payments isn’t eroded as much.
Lastly, investing in bonds may come with a currency risk. If the bond purchased is denominated in another currency, the return which you may receive in your local currency can be affected by exchange rates. For example, say you live in the UK, and you purchase a US treasury bond. The payments you will receive from the bond will be in dollars. If the pound is trading cheaper against the dollar than when you initially purchased the bond, these payments will be worth less than you originally anticipated when the pound was more expensive.
Therefore, although bonds are often thought of as a ‘risk–free’ investment which offers stable returns, there are many risks which are associated with investing, some of which have been covered in this article. This accentuates the underlying need for scenario analysis, considering different economic outlooks and how they could influence your investments.