/ 30 May 2011

Bonds 101 — a guide to prices and yield

When trying to understand bond ratings, think back to your school days (unfortunately it may seem like many moons ago) — as with school, lots of AAAs with a few +’s is good. Fewer B’s and a few minus signs is bad. Anything below BBB (Investment Grade) is considered bad.

Many institutions, such as pension schemes, insurance companies, amongst others are forbidden to invest in these instruments due to stringent investment guidelines as stipulated by their mandates.

The impact of interest rates
If there is a bond paying 5% and new bonds of similar quality and maturity are paying 6%, nobody will want to buy the “poorly” paying bond at full price.

Think about your personal circumstances. You would like to borrow a few rand, and there are three providers which are charging 5%, 6% and 7% respectively. It is self-evident that you should opt for the lowest interest rate option, making the money you borrow cheaper.

Yet many investors get confused by the inverse relationship between bond prices and interest rates (yield).

A simple example:
Say you have a five-year bond with one year more to go before the bond matures. Let’s assume the bond was issued at R1 000 and the original yield at issue was 5%. That means at the end of the term, you will receive your R1 000 and R50 in income (R1 000 x 5% = R50).

Now let’s say that a new bond of identical cost, R1&nbs;000 and credit quality that will run for one year has a yield of 6%. If you buy the new bond, at maturity you will have the original investment of R1 000 and a return of R60 in interest (R1 000 x 6% = R60).

The question now is how will you sell your five-year bond? Nobody with a handful of brain cells will buy a bond that pays R50 when similar new bonds pay R60!

Here is what will happen — you will sell your bond for R10 less. Instead of selling the bond for a R1 000 (known as its PAR value) you will sell it for R990 (give or take).

At maturity, the buyer will get his R50 in interest and an additional profit of R10 as the bond he paid R990 for is now worth a R1 000. Essentially, you have lowered the price of your bond and the yield increased to 6%. This yield to maturity is now 6% even though the original stated interest rate remains at 5%.

Importantly, the adjustment may be slightly less or more than the exact R10 because the frequency of interest payments and the length to final maturity are part of the calculation. For example, if the bond pays no interest until final maturity, it will be hit a little harder than one paying out every quarter, because interest can be reinvested at higher rates as it becomes available. A bond that runs longer will be more seriously hammered than one just about to mature when interest rates rise too.

The process works in reverse when interest rates fall. At that point, older bonds that pay more become more desirable, and a buyer will pay over fair value to get them. When interest rates are falling, bonds, with more years until maturity and longer time (duration), become much more valuable because they pay more and for longer.

Why is this important?
Pension funds and “later” life stage portfolios have a larger allocation to bonds. The impact of this can be quite substantial from a return perspective due to the inverse relationship between bond prices and interest rates. It is therefore important that you have a good understanding of how bonds work so as to properly assess the performance of your investments. It also means you can be a more active and responsible investor, which can only be a good thing.

Paul Harrison is head of sales at Sanlam Multi Manager International.

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