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Understanding Bonds

Updated: Dec 12, 2022

What are Bonds?

Bonds are a type of contract issued by either companies (Corporation Bonds) or governments (Treasury Bonds) in order to raise funds as a form of debt. They sell the bonds to investors at a face value (when first issued in the primary market, otherwise traded at market price on the secondary market) and make interest payments (known as the coupon) to the investors regularly until the maturity date.

The benefit as an investor is that you have a stable stream of income (although nothing is 100% guaranteed when it comes to investments) flowing from your investment. As an example, if you own a bond with a face value of £100 that offers a 5% coupon rate, you will receive this amount every year (depending on the terms of the Bond it could be in one lump sum or split in multiple payments during the year). Meaning you would receive a total of £5 every year until the maturity date. At the end of the maturity date you will receive your initial investment. If we assume a 3 year maturity date, then you would have received £15 over the lifetime of the bond.

The down side on the other hand is that you do have to leave your money untouched, however this is no different to other investing options. The risk you are exposed to is the possibility of the issuer of the bond defaulting, i.e. companies could declare bankruptcy as can governments (although this is less likely in developed countries). This risk is normally reflected in the coupon rate, the higher the risk, the higher the coupon.

Bonds don't always trade at face value, as you do not have to wait until the maturity date to sell the bond on to another investor if you think you can make a profit or for some reason you need to get your cash back. If an investor purchases a bond at a cheaper price than the face value, it is said that the bond is at a discount. As they would still receive the same 5% coupon, the yield on the bond is actually higher. If we continue with the above example where the market price is discounted to £95 that would mean that the yield is now 5.26%. The yield is calculated as a % given by coupon/market value, hence there is an inverted relationship between the yield and market price.

Bond yields are highly affected by monetary policies which at its core is about determining interest rates. Central banks use interest rates (among other instruments) to set monetary policies and influence the economy. The policies are determined by the country's central bank, in the US this is the Federal reserve and in the UK it is the Bank of England. Central banks enact different monetary policies, depending on the various parts of the economic cycle that their respective countries are in. Each central bank also has a different objective. Typically, developed market central banks will target a certain level of inflation or price stability, typically around 2%. If inflation is above that target, central banks will tend to raise rates in order to prevent overheating of the economy.

Economic Landscape

When learning new financial concepts, it is important to not only learn those new terms but even more importantly is understanding how they fit into the bigger picture. This is especially true when it comes to finance and the economy. Hence I'm going to take a moment to recap some of what has been happening in the economic landscape in 2022 as bonds have also played an important part in the news.

In recent times data released showed that UK inflation has risen to a more than 40-year high at over 10% (powered by high gas prices and energy bills driven by the War between Russia and Ukraine) leading to the current cost of living crisis. The below graph shows the sharp increase in UK bond yields caused by the increase of borrowing costs (rise of interest rates) by the Bank of England.

In the market turmoil after the mini-budget, the value of UK government bonds fell sharply as investors began to lose faith in the credibility of the Truss administration to run a sustainable tax and spending policy. This meant a rise in yields – which move inversely to bond prices – in a reflection of the increased cost of government borrowing.

Mortgage lenders reacted by pushing up mortgage loan rates above 6% on two-year fixed deals, leaving many homebuyers facing thousands of pounds a year in higher annual payments.

In late September, the British government decided to cut taxes (as part of the mini-budget proposal) without making plans to compensate for the loss of revenue. These decisions were made even though various inflationary pressures were (and still are) harshly impacting the government and its citizens. Upon news of the tax cuts, investors lost confidence in the British government's ability to maintain its economy and sold off their holdings in British assets in large numbers. The loss in value of the British pound sterling is one of the direct results of the lack of faith investors had in the British economy. The British pound briefly reached near-parity (equality) with the U.S. dollar toward the end of September 2022. The pound reached $1.035 before inching back upwards

As a result pensions funds that were invested in LDI schemes (Liability-driven investing) faced rolling “margin calls” as the value of the bonds they had pledged as collateral collapsed. The funds then moved to sell other long-dated bonds they held to cover the cash demands, which in turn led to further selling pressure in the bond market in a self-reinforcing downward spiral.

The Bank of England (BoE) intervened as best it could to counteract the spike in interest rates and the pound's loss of value. The bank stated it plans to engage in large-scale purchases of government bonds to restore the market to normal operating conditions. The Bank of England started bond auctions during the last week of September 2022. As a result, the pound's value rose slightly, and interest rates dropped.

It is impressive to see how one wrong decision can make things spiral into a domino effect across the whole economy. It has been quite the year, but the road to recovery looks like it's going to be a long one. Buckle up and budget through!

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