A bond is like an IOU written by a government or a company. Bonds produced by these ‘issuers’ are bought by investors, who effectively lend them money for a defined period and at a fixed rate of interest.
The main types of bonds are:
• government bonds;
• index-linked bonds, which are linked to an inflation index so that payments rise with inflation;
• corporate bonds, also known as credit, with investment grade credit rated ‘BBB’ or above and high-yield rated BB or below; and
• floating rate notes, which carry a variable interest rate linked to a benchmark such as Libor.
There are various types of bonds with different characteristics, but generally speaking bonds offer a fixed interest rate, known as a ‘coupon’, that is paid on an annual or semi-annual basis. They also have a maturity date when the full initial cost of the bond - the ‘principal’ - is repaid.
Bonds’ ‘income yield’ is the coupon divided by the market price. For example, a bond with a coupon of 5 per cent trading at 87 per cent to its face value will have an income yield of 5.75 per cent. Yield therefore moves in inverse proportion to price.
Another common measure of a bond’s value is its ‘gross redemption yield’. This takes account of the annual interest rate on a bond, including any capital gain or loss if it were held to redemption, and assuming that all coupon and principal payments are made on schedule. It does not make any allowance for tax paid by the investor on the return earned.
Although most bonds pay out fixed cash flows - coupons and the face value - to investors, the price of a bond changes over time as it is traded in the open market. A number of fundamental factors can cause changes in bond prices.
For example, generally the lower the credit rating on a government or company, the higher the risk and therefore the higher the coupons and yield. Changes in the rating of bond issuer’s creditworthiness will, in most instances, be reflected in the coupon they offer.
There are a host of other factors that can counteract this, as happened with the US and UK, which have been able to borrow at lower rates and offer smaller coupons due to demand for their relative safety, despite both countries being downgraded by major ratings agencies.
Other factors include: the outlook for inflation; actual and expected changes in interest rates; the outlook for economic growth; supply and demand of bonds; and alternative investment opportunities.
The impact of these factors can vary by bond market sector and some factors can indeed be positive for government bonds and negative for corporate bonds or vice versa.
Strong economic growth, for example, may be negative for government bonds, if it fuels investors’ concerns over inflation. At the same time, corporate bonds may be positively impacted by the resulting improvement in corporate earnings.
