Isn’t convexity a type of contact lens?

Most investors are familiar with the basic characteristics of bonds – low risk and correspondingly lower returns, and low correlations with riskier asset classes thus offering diversification benefits. However, few venture further to gain a better understanding of the asset class. The financial jargon associated with fixed income investments is a mind-whirling mix of “convexities”, “yield-to-maturities” and “durations”, which usually sends even the most enthusiastic investor into a drowsy state.

Unfortunately, it is difficult to examine the asset class without the slightest hint of financial babble, but given the wide spectrum of opportunities available in the vast fixed income universe, we believe that an examination of different bond classes will be a beneficial and enlightening exercise. Ultimately, we hope to provide our readers with a better understanding of the different types of bonds available for investment.

What’s a bond?

Unlike stocks which represent ownership in corporations, bonds are essentially a form of lending. When an investor buys a bond, he effectively lends money to the issuer, which could be a company (corporate bond) or a country (sovereign bond). Unlike stocks where future returns are uncertain, bonds usually have a known rate of return and a maturity date. The borrower pays the bond holder a predetermined rate of interest on the loan amount (called the yield), and repays the loan upon maturity of the bond.

Why Prices and Yields Move in Opposite Directions

Since the maturity and yield of the bond are fixed, the bond’s price is allowed to fluctuate according to the return that investors require on that particular bond. When investors require a lower rate of return on the bond, the bond price rises so that the yield (called the yield-to-maturity) on the bond is lower. Conversely, when investors demand a higher return, the bond price declines, resulting in a higher yield-to-maturity.

Looking at spreads to assess bond classes

Since returns on bonds are known at the point of investment, a relative measure of valuation is often utilised. By making comparison with yields on the safest government bonds (eg. US Government bonds), investors have an idea of the “premium” they receive in addition to risk-free securities. For example, if a five-year US government bond yields 2%, an investor would expect to receive a higher yield on other bonds of a similar maturity to compensate for the additional risk. This difference in the yield on a particular bond and the risk-free benchmark bond is called the “spread”.

A wider spread means that investors earn a larger premium for holding non-risk-free securities, while a narrower spread indicates that this premium is diminished. Spreads are usually compared on a historical basis for each bond class, as a measure of whether the bond class is more attractively valued (spreads are wider than average) or less attractively valued (narrower spreads than average).

Key considerations: Interest rates and duration, credit quality, currency

Interest Rates and Duration

Given that yields on bonds are based on benchmark interest rates, changes in the interest rate environment can impact bond prices. The typical structure of a bond (fixed yield and maturity) means that bond price is allowed to fluctuate based on the yield demanded on that particular bond. The longer the duration or maturity of the bond, the more susceptible the investor is to interest rate risk.

[See also “Bond Duration - What, How & Why?”]

Credit Quality

The credit-worthiness of the borrower is an important consideration - any normal person would be reluctant to lend to a friend with a poor history of debt repayment. Likewise, investors are less enthusiastic about buying the bonds of less-reliable countries and companies and thus demand higher yields, given the increased risk of default. In general, “investment-grade” bonds are of higher credit quality compared to “non-investment grade” bonds (otherwise known as “high-yield” or “junk” bonds).

Currency

Currency fluctuations may impact stock investors in different ways: while a depreciating foreign currency may result in a translational loss in terms of stock price, the company may be an exporter which benefits from a depreciating currency, which can significantly increase revenue and future business prospects (Japanese exporters are a common example). On the other hand, bond interest and principal payments are known, and the impact of currency fluctuations may make or break the bond’s overall return to the investor. An investor based in Singapore who purchases a ten-year US-dollar denominated bond eventually receives the bond principal (in ten years time), and will face USD currency risk until maturity of the bond. If the USD depreciates against the SGD, the investor will receive a lowered rate of return. Conversely, if the USD appreciates against the SGD, the investor’s returns will receive a boost.

Stay tuned for Part 2 - Developed Country Sovereign Bonds

Having barely scratched the surface of the fixed income asset class in this introduction, we will be examining the different key categories of bonds which make up the bond universe in the next part of this series, starting with developed sovereign bonds, one of the lowest-risk segments of the global bond market.

Next: Part 2 - Income Investing Series: Developed Sovereign Bonds (Coming Soon!)