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Money: Bonds – still a mystery to many

05 Jun 2020

Bonds 101 - What is a bond, how does it work and what use are they?

Everyone knows what a bank term deposit is, so I think that is the place to start our story.

A bond is just like a bank term deposit, except it is bought and sold in a secondary market rather than held to maturity.

All will be revealed below...

Bank term deposits

Banks offer term deposits to the public in what is known as a primary market.

When you invest in a bank term deposit, no one has owned it before. Hence, a primary market. Each time someone wants a bank term deposit, the bank writes a new one especially for you, and it lasts until the maturity date expires: 3 months, 6 months, 1 year, 5 years, and so on. This is the term of the deposit. Hence the name, ‘term deposit’. An investment for a fixed term with a known and fixed interest rate.

Take the market for cars. When you buy a new car, direct from the manufacturer, this is a primary market transaction.

After several years, you need to buy another new car. What do you do with your old car? You can sell it in the used car market, and that is an example of a secondary market.

Secondary markets are where pre-owned things are bought and sold.

And this brings us back to bonds.

Bonds are issued for the first time in a primary market, by governments, banks and large businesses. Once taken up by investors, they can then be bought and sold in a secondary market, just like with our used-car, or with shares in the share market.

When you think about it, the bank term deposits are not very efficient, are they? Each one individually produced for anyone who walks in off the street. All for different amounts. Sometimes even individually haggled over on the interest rate. Have you ever negotiated with a bank on their term deposit interest rate? They will often improve their initial offer if you put a bit of pressure on them. About as easy as getting a discount on a new car.

At this stage, let us list some of the differences between a bank term deposit and a bond:

  • You cannot haggle over the interest rate or the term of a bond. A bond is designed well in advance of buying it and it has a fixed term, a fixed interest rate and a fixed principal (the standard unit of investment).
  • In a new issue, every bond is exactly the same. There might be, say, 50,000 of them issued in a new issue in the primary market, each worth $1,000, all exactly the same. Homogenised.
  • Let us imagine that ABC Bank has issued a series of bonds as described above. The Bank is hoping to raise $50,000,000 by issuing these bonds and it is hoping that they are all taken up by investors.
  • In our example ABC Bank has decided that their bond will mature on 15 June 2027 so at that time, whoever owns these bonds will get their $1,000 back.
  • In the meantime, ABC Bank has taken advice and decided that it will pay an interest rate of 5% per annum. This equates to $50 per annum on every $1,000 bond held, whoever happens to hold it at the time the interest is paid out (usually $25 twice a year).
  • Once issued, the owner of one of these bonds (let us imagine that it is your KiwiSaver fund that has bought some) can sit on them until 15 June 2027. Or, if they wish, they can go and sell them on the secondary market.
  • There is a secondary market for bonds? Yep. That is right. Unlike a term deposit, a bond, once issued, can be bought, and sold in the New Zealand secondary bond market, which is about the same size as the New Zealand share market. It is big and very important to the workings of the New Zealand financial system.
  • Where is this ‘bond market’? It, like the share market, is web-based. It is all online.

Selling a bond in the secondary market

bonds3

This is pure magic.

Don’t sit around on an old bank term deposit and wait until maturity. Own a bond instead and sell it, or buy more, whenever you like!

The rate of return is likely to be higher than a term deposit for a similar level of risk.

Trade them, just like shares.

Go on. You know you want to.

Or you can leave it to your financial adviser or fund manager.

But the principle of buying and selling bonds is at the heart of all finance. The bond market is where interest rates are set, by willing buyers and willing sellers, every second of every day.

The thing about bonds is that they can change their value any time. Just because you paid $1,000 for a bond in the primary issue does not mean to say that you are going to get $1,000 if you sell it early.

The only way of guaranteeing the return of your principal is to wait until maturity when you will (hopefully) receive the initial investment back (assuming the organisation is still around).

If you want to sell your bond early (or buy another one) you go to the secondary market and see what you will get for your $1,000 bond.

What determines what your $1,000 bond will fetch after you have held it for, say, one year?

  • Remember your bond is paying out $50 in interest payments every year giving a 5% annual return. This 5% is the yield that you bought it at. It was the going interest rate for that type of bond with that type of risk at the time you bought it. It will not be the going interest rate a year later.
  • A year after initially buying your bond, let us say that interest rates for that type of bond have fallen to 4%. What is it likely to be worth on the secondary market?
    • The buyer is going to be getting $50 per annum. That doesn’t change.
    • You will get more than $1,000 for selling your bond at a return of 4% per annum. Can you see why?
    • The investor who buys your bond is still going to be getting $50 a year until maturity and they are happy to be receiving 4% per annum as interest rates have fallen. They will pay more than $1,000 to make it work at 4% per annum.
    • The simple math’s turns out that you would get $1,250 for selling your bond on the secondary market. The (simple) math’s is: $50 ÷ 4% = $1,250.
    • The actual math’s is more complicated than that as we need to factor in that no one is going to pay $1,250 for a bond and only get $1,000 back at maturity. An extra $250 is too much to pay for the higher $50 per annum for six years. We also must factor in the wait for up to 6 years to get their $1,000 back. The actual sale price of the bond is likely to be more in the realm of $1,050. Still, a profit has been made. The principle is correct.
    • Likewise, if interest rates have gone up to 6% over the year since you bought the bond at 5% yield you will get less than the $1,000 you paid for it. That said, you can now go and reinvest the $950 dollars or so you received at 6%, a higher rate of return for the following six years. It sort of all comes out in the wash.

What about risk and return

Bonds come with risk, and so do bank term deposits.

The risk in a bond is primarily the risk that the issuer defaults and stops paying the regular annual interest payment and the final return of capital, the $1,000.

This is also true of bank term deposits. There is no absolute guarantee that a bank will survive. They are commercial businesses similar to all other businesses. They can go bust too.

The principle here is that the higher the risk of the institution going bust, the higher the expected interest rate you will want to earn to hold it. Risk is linked to return, just like all investments.

How are bonds useful in an investment portfolio?

Bonds do not go up and down in value as much as shares. They are less volatile. They are a steadying influence.

Bonds can go up in value when shares are falling in value. They march to the beat of a different drum than shares. For instance, when the level four lockdown happened recently and our economy stalled, the Reserve Bank dropped official interest rates from 1% to 0.25% per annum and banks followed suit, eventually.

Share markets fell more than 30% in a couple of weeks while bonds held their value fairly well, once some liquidity problems were sorted out, and then they settled into their new, lower interest rate environment producing a nice capital gain in portfolios that held them.

Bonds are not a perfect foil for shares, but they do provide some diversification benefits in a diversified portfolio.

Keep asking great questions …

 

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