The Global Financial Crisis (GFC) has certainly proved to be a testing time for investors. With shares and property valuations in dramatic decline, many have looked to the so-called ‘safe haven’ of bonds for the income and capital stability that they can provide. However, during this crisis we have seen the landscape and the dynamics of investments change considerably and bonds have not been immune.

While simple in theory, bonds can be quite complicated with a variety of external factors affecting them and so in this article we will discuss how bonds work and highlight some of the risks associated with them. In addition, we will look at the role debt markets play in financing long-term government and corporate investment.

What is a bond?

A bond is simply a loan between two parties. The lender (investor) is the party who buys the bond generally at a fixed rate of interest. The borrower is the party that issues the bond.

The borrower is typically a government body or large corporation that issue bonds as a way of financing operations – such as government road and infrastructure projects. Like any loan, the borrower must attract investment by offering interest on the money they are lent.

Bonds are issued with an interest rate payable for a set period of time and when that period expires the investor’s original capital investment is returned. The interest rate is known as the ‘coupon’. The date of expiry is known as the ‘maturity date’. The ‘face value’ is the value of the bond returned at maturity.

For example, on 17 July 2009, the Australian Government issued three-year bonds with a face value of $1,000,000 and a coupon of 5.75 per cent. The lender (investor) will receive an interest payment paid by the Australian Government of $57,500 per year (5.75 per cent of $1,000,000) for the next three years. On 15 April 2012 the investor will be paid back the bond’s face value of $1,000,000.

How do bonds work?

Once bonds are issued they can then be traded on an exchange and so the price of the bond may change depending on demand, supply
of buyers and sellers in the market and underlying interest rates in the economy. However, the bonds face value, coupon and maturity will always remain the same. Therefore, any change in price will also change a bond’s yield, or the return on the bond based on its current price.

For example, a bond with a face value of $1,000 and a coupon of 6 per cent (or $60) has a yield of 6 per cent. This is determined by dividing $60 by $1,000.

But if the price of the bond rose to $1,200 investors would still receive a coupon of $60 – pushing its yield back to 5 per cent ($60 ÷ $1,200). If the bond was to fall to $600, the yield would rise to 10 per cent ($60 ÷ $600).

This illustrates the inverse relationship between the price and the yield of a bond, being that when a bond yield falls, the price will increase and when the bond price falls, the yield will increase.

Why does the price of the bond change?

The price of the bond is influenced by many factors including the credit rating of the government or corporation, the interest rate in the market, the interest rate on comparable bonds, the term to maturity and a variety of other factors. As an example assume the same bond as above with a face value of $1,000 and a coupon of 6 per cent. If interest rates are at 6 per cent then an investor is getting the same return from the bond as they are from the bank.

Should interest rates rise by 1 per cent to 7 per cent, then a potential investor would be better off to keep the money in the bank and earn 7 per cent than purchase a bond to earn 6 per cent. In these circumstances supply and demand in the market would see the price of the bond fall to around $850. Why $850? Well if you purchase the bond on the market for $850 you will still receive the coupon of $60 (6 per cent of the face value of $1,000), but as you have only paid $850 your return is now 7 per cent ($60 ÷ $850). Thus the market has repriced the bond to reflect the current prevailing interest rate.

This example ignores a variety of other factors, which will all affect the value of the bond in some way, but demonstrates how one of these factors can influence it.

Why do governments use bonds?

Government borrowers have historically dominated the fixed income market, issuing bonds to finance their budgets when expenditure is greater than tax receipts. However in 2003 the Australian Government considered removing the federal bond market as they had almost removed all federal debt by slashing over $40 billion of debt over six years. After some consideration the Howard government chose to keep this market for two reasons.

Firstly, the Australian bond market helps ensure market liquidity and can remain fully operational without Treasury being in debt. Secondly, by retaining a bond market the Federal Government’s cost of funding is minimised as it appeals to retail investors, institutions (including superannuation funds) and foreign central banks.

This decision has proved to be a wise one because in this current economic climate the government will be relying on the bond market to help fund the economic stimulus packages that it has rolled out over the past 12 months. In October last year a $10.4 billion stimulus package aimed to assist pensioners, families and first-home buyers was announced.

Before this stimulus had completely rolled out the government announced in February 2009 a further $42 billion package in an attempt to bolster confidence in the local economy. To help fund this package Treasury bond issuance increased to $78.4 billion as of June 30 2009 with further increases expected in the coming years. While this may seem like a large number in comparison to other countries notably Japan, the United States and United Kingdom; Australia’s debt is minimal when looking at its debt level as a percentage of the size of its economy (GDP).

Are there risks when investing in bonds?

A common perception of fixed interest securities is that the term ‘fixed’ implies certainty of return and therefore these instruments contain little or no risk of volatility. However bonds do carry a level of risk that needs to be considered.

The two predominant risks associated with bonds (and other fixed interest investments) are interest rate risk and credit risk. Interest rate risk is the threat that interest rates will rise, lowering the attractiveness and price of the bond that was purchased at a lower rate (as illustrated above). Credit risk is the threat of the issuer (Government or Corporation) defaulting on repayments and thus the lender (investor) may not receive their expected income and potentially their capital at maturity.

These risks can be reduced by using professional managers who can provide diversification into a pool of bonds that reduces overall risk, as well as help to manage interest rate risk through an economic cycle.

An investment in bonds is an important part of a well-balanced portfolio as it provides diversification benefits and helps reduce the volatility that comes from equities and property. However when making a bond investment it is important to focus on the longer-term benefits of holding this asset class, as in the short-term values and returns can vary as a result of changes to the wider economic environment.

This article is not a definitive analysis of bonds as they vary in their complexity and structure throughout the world.

Hopefully we have been able to touch on some basic principals that will bust though some of the jargon in news reports.