Investor Guide to Bonds

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1 Investor Guide Investor Guide to Bonds threadneedle.com

2 Introduction Why invest in bonds? Although your capital is normally considered safe in a traditional deposit account, low interest rates have eroded the returns from banks and building societies in recent years, while equity markets have displayed heightened volatility. For these reasons, bonds have moved increasingly into the spotlight. There is no doubt that bonds can provide real benefits for a wide range of investors, but the advantages and risks of bond investing are all too often misunderstood. In this guide, we investigate the bond market and its different sectors, as well as the risks and rewards associated with various types of bond. To help your understanding where we refer to specific terms, we have included a jargon-buster on page 11. Please read this important information. You cannot predict future performance by looking at past performance. The value of investments, and the income from them, can go down as well as up, and you may not get back what you put in. Threadneedle is unable to provide financial advice and you should not interpret anything in this guide as advice. If you are unsure about anything you should speak to a financial adviser. For details of one in your area please go to The material in this brochure is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

3 What is a bond? A bond is basically an IOU issued by a government, quasigovernment body or a company. When you buy a bond you are effectively lending the issuer money for an agreed amount of time and at an agreed rate of interest. Both of these factors will be specified in the name of a bond when it is issued. In return for the loan, the issuer agrees to pay you a fixed amount on a regular basis. This payment is called the coupon, and is effectively the interest on the loan. Crucially, the issuer also agrees to pay you back your original loan in full at the end of the agreed term. So, bond investors get a regular and pre-agreed stream of payments for a fixed time period, then have the original sum invested returned to them at the end of the period. Issuer An issuer is a company, government or quasi-government body that wishes to borrow money to fund its future plans. Coupon The coupon is the amount of money paid each year as interest by the bond issuer to the investor. Principal The borrower issues a bond to the investor in exchange for a sum of money known as the principal. How a bond works To illustrate how a bond works, a fictional bond issued by Widget Company is shown below. If you buy this bond, you effectively agree to lend Widget Company 100 for a period of five years. Throughout this period, Widget Company will pay you a coupon of 5 per year, and at the end of the period they will also return your original investment of 100. Widget Company We promise to pay the holder on 31 December 2015 the sum of 100 Meanwhile, you will get: 5 on 31 December on 31 December on 31 December on 31 December on 31 December 2015 Illustrative example 3

4 Why bond prices change The most important difference between a bond and a normal IOU is that bonds can be bought and sold on the stock exchange. If bonds were not tradeable in this way, then bond prices would remain completely stable, but investors would have to wait some years to get their capital back. However, because bonds are tradeable, you can sell your bonds at any time. And, just like cars, houses or anything else that can be bought and sold, the price you get will depend on how much you want to sell them, and how badly others want to buy them. Because these factors depend in turn on the ever-changing investment climate, bond prices are constantly fluctuating. Prices and yields You often hear the word yield used when describing bonds. The yield is a measure of the return available from a bond, given the agreed coupon, the time left to redemption and the current price. In other words, it is a way of measuring the attractiveness of an individual bond. Because bonds are not always held to redemption, there are different methods of calculating the yield. Running yield This measures the return if you bought the bond today but did not hold it to redemption. Going back to our example, imagine that after four years the Widget Company bond price is standing at 99. The coupon remains unchanged at 5 this never changes, since it was agreed at the outset. In this case, the running yield is 5 99 = 5.05%. Conversely, if the price was 101, the running yield would be = 4.95%. Redemption yield This is similar to the running yield, but assumes that you will hold the bond to redemption (maturity). To use the same examples again, if after four years the price of the bond was 99, you would get your 5 coupon in the fifth year plus 100 back on the redemption date i.e. 1 over the price you paid. So the redemption yield is (5+1) 99 = 6.06%. However, if the price was 101, you would get your 5 coupon in the fifth year but would effectively lose 1 because even though you paid 101 for the bond, you would only get 100 back on redemption at the end of the year. So the redemption yield in this case would be (5-1) 101 = 3.96%. Redemption date The redemption date is when the original sum is repaid to the investor, and coupon payments cease. It is also known as the maturity date. Yield facts nprices and yields move in opposite directions. In other words, when prices rise, yields fall and vice versa. n Different yield calculations can provide quite varied results. You should always take care to clarify which type of yield is being quoted. 4

5 Risks and rewards of holding bonds Although we have seen that bond prices do fluctuate as market conditions change, these fluctuations are generally much smaller than changes in the prices of some other investments, such as equities. The main benefit of holding bonds is the regular coupon payments they provide. Traditionally, this combination of more stable prices and regular payments has made bonds an attractive choice for income-seeking investors. The risks involved in bond investing fall broadly into two camps: interest rate risk and credit (or default) risk. lnterest rate risk Imagine again your Widget Company bond that we introduced on page 3, paying a coupon of 5% per annum. If bank deposit rates rose to 7%, you would be able to get a better return by keeping your money in the bank than from your bond. So you would seek to sell your bond. The trouble is, so would everybody else. The result is that the price of bonds with coupons of 5% would fall. Conversely, if deposit rates fell to 1%, your bond would represent a very attractive investment, and the price would rise. Inflation has a similar effect, particularly on bonds where the loan is over a longer period. Indeed, inflation is the enemy of bond investors. If inflation rises, the purchasing power of your coupons far into the future falls, so the bond becomes less attractive and the price falls. However if inflation falls, your future coupons are likely to be worth more in real terms, so your bond becomes more attractive and the price rises. Interest Interest rates/inflation rates/inflation Bond prices Bond prices Bond prices Bond prices Interest Interest rates/inflation rates/inflation 5

6 Credit or default risk This is the risk of the issuer going under and being unable to pay coupons or repay the original sum invested at redemption. The likelihood of this happening varies from one issuer to another, and from one day to the next according to economic and business conditions. For instance, the UK government issues bonds, which are often referred to as gilts (originally the certificates were gilt-edged hence the name). It is accepted that the UK government is extremely unlikely to default on its bond payments, and so gilts carry very low default risk. Companies, however, could run into financial difficulties, and so bonds issued by companies (called corporate bonds ) carry higher default risk. Different factors influence gilt yields of varying maturities. For example, yields on short dated bonds (up to five years to maturity) are mostly influenced by movements in official interest rates (base rates), whereas at the long end of the spectrum (gilts with a residual maturity of over 15 years), expectations for economic growth and inflation are key considerations. Within the corporate bond market, detailed analysis is carried out into the financial strength (or creditworthiness ) of individual companies, and bonds are rated according to the likelihood of default. To take an example, a large, established pharmaceutical company operates in a sector where profits tend to be fairy insulated from the economic cycle. As such, it is deemed less likely to default than a newer company operating in a more risky area. The economic outlook, the rise and fall of different industries and the competitive position of companies within those industries are just some of the factors that can affect the longterm ability of an issuer to repay its debts. This is why credit ratings of individual companies change over time, and why investing in bonds requires constant in-depth analysis. Of course, past performance is not a guide to future returns. The value of investments and any income from them may fall as well as rise and you may not get back the original investment. In the event of a company bankruptcy there is a hierarchy which details the order in which investors are paid out from the assets of the firm. In this situation, bond investors are treated as preferential creditors compared to equity holders although it should be remembered that bond holders are not paid out first in the event of a company going bankrupt. 6

7 A range of investment opportunities The different levels of risk result in a spectrum of bond coupon levels. For example, it is only natural that investors should demand a premium for the extra risk they are taking on when lending money to a less well established company. Therefore, bonds issued by these firms typically have higher coupons than those issued by well financed blue chip companies hence the term high yield is often applied to higher risk corporate bonds. Different types of issuers are affected in different ways as events unfold in the market. For example, changes in interest rates have a greater effect on government bonds, while changes in the economy and corporate profitability have a greater effect on corporate bonds. Like any marketplace, the bond market does have inefficiencies, and sometimes these inefficiencies mean that the excess returns available from one bond or sector more than outweigh any extra risk involved. These opportunities are difficult for private investors to discern on their own. But by carefully researching bond issuers and weighing all of the economic and technical factors, professional bond fund managers aim to construct portfolios of bonds that are ideally suited to investment conditions. This is why many bond investors prefer to access the bond market via investment funds. Risk/return ready reckoner Type of bond Main influences Risk level Yield level Government Interest rates Low Low Investment grade Interest rates / Corporate news flow High yield Corporate news flow / Company finances Moderate High Medium Investment grade and high yield (speculative grade) bonds Relatively well financed companies bonds are referred to as investment grade, while bonds issued by less secure companies are known as high yield. Investment grade bonds can be rated AAA (the most creditworthy with the lowest yield) through to BBB, while high yield bonds can be rated BB or lower. These are the ratings defined by Standard & Poor s (S&P), one of the foremost credit rating agencies, and are shown below alongside the classifications from Moody s, another leading credit rating agency. Rating agencies can change their views on the issuer s creditworthiness, which can lead to ratings upgrades or downgrades, with corresponding positive or negative implications for the company s bond prices. High Investment Grade Speculative Grade S&P Moody s Description AAA Aaa Highest credit quality AA Aa Very high credit quality A A High credit quality BBB Baa Good credit quality BB Ba Lowest degree of speculation B B Speculative CCC Caa Speculative CC Ca Highly Speculative C C High default risk D D Default 7

8 Yield curves and spreads Yields for the same type of bond but with different redemption (maturity) dates can be depicted graphically. For instance, the prevailing yields on 5, 10 and 15 year UK government bonds may be plotted on a chart. A yield curve essentially plots current bond yields against their time to redemption, enabling investors to compare the yields of short, medium and long dated securities at any given time. Normal yield curve Yield % 1 year 30 years Maturity This is significant as yield curves change over time and fund managers seek to analyse where the best value is (i.e. when is it the best time to purchase a bond taking account of its correct price, its yield and its maturity date). A normal yield curve, as shown above, will show higher yields for longer-dated bonds than for short dated issues. By plotting the yield curves of different types of bonds on a single chart it is possible for a fund manager to assess their relative attractiveness. Yields will reflect the riskiness of the bond investment and consequently corporate bonds offer a higher yield than government securities. The difference between the two is known as the spread. The spread can widen or contract depending on a range of factors such as the prospects for the economy and inflation (fundamentals) and the demand/supply outlook (technicals) for the bonds. 8

9 Bond yields also reflect the riskiness of the investment As with any investment, the higher the potential risk, the higher the potential reward and investing in bonds follows the same thinking. For example, a bond issued by a government such as the UK is seen as a very safe investment as the UK is very unlikely to default on its obligations. Therefore to attract investors, the UK government does not need to offer a very high rate of interest rate whereas a corporation issuing a bond is seen as a higher risk and therefore has to issue bonds paying a higher rate of interest to attract investors. The chart below illustrates the different yield curves of two illustrative examples for a government bond and a bond issued by a company. The yield curve and bond spreads Corporates Spread Yield Government Yield Curve Maturity The term spread refers to the amount of extra yield that is earned for holding bonds with more risk than government debt. Using the example above, the spread illustrated as the different in yield between the Government Issue and the Company Issue. Duration Managers of bond portfolios pay close attention to duration. This is an approximation of the sensitivity of the price of a bond to changes in yield. Maturity is the main driver of duration although there are also other relevant factors. Quoted in years, duration indicates the average exposure to market risk and allows bonds with different coupons and maturities to be compared. Bonds with a longer duration tend to react more to changes in interest rates than those with a shorter duration, and therefore bond fund managers actively manage duration to reflect their views on the path of interest rates. 9

10 Summary As we have shown in this guide, the bond market is very varied and offers a wide variety of risk and return combinations, as well as behaving differently to equities and other asset classes. Consequently, we believe that bonds have an important role to play in a diversified portfolio. In the same way that equity fund managers would look to gain an in-depth knowledge of a company, its market and whether it is valued correctly by the market, bond fund managers also undertake an equally in-depth analysis around each bond held within a portfolio. Talented fund managers are able to consider all of these moving parts and use their experience and judgement to make high conviction calls on which investments offer the best potential for their clients. At Threadneedle our highly regarded team works together, debating and challenging consensus views to ensure that our best investment ideas are leveraged across portfolios. This approach has delivered excellent long-term performance, and we are confident that our clients will continue to benefit from this expertise in the future. As always with any type of investment, please be aware that past performance is not a guide to future returns and that you may not get back your original investment. Threadneedle is unable to provide investment advice so if you are unsure whether an investment is suitable for you, you should contact a financial adviser. For details on one in your area visit 10

11 Jargon-buster Coupon the amount of money paid each year as interest by the bond issuer to the investor Credit rating the independent rating given to an issuer s bonds. They run from the highest rating AAA through to the lowest D the higher the rating, the lower the risk of default. Default if a bond issuer cannot afford to pay the coupon or principal at maturity. Duration This is an approximation of the sensitivity of the price of a bond to changes in yield. Investment grade the bonds issued by relatively well financed companies. High yield the bonds issued by less secure companies. Issuer a company, government or quasi-government body that wishes to borrow money which they do by issuing a bond. Maturity date see redemption date. Principal the amount paid by the investor to buy the bond originally. Redemption date the date when the original sum (the principal ) is repaid to the investor and the coupon payments cease. Also known as the maturity date. Redemption yield also known as yield to redemption, maturity yield and yield to maturity. This yield takes account of the bonds coupon divided by the current market price of the bond but also allows for the change in capital value for the set period until redemption i.e. the total return on the security express as an annual yield. Running yield also known as current yield, interest yield, earnings yield and flat yield. This is the coupon payments of a bond divided by its current market price. It is one of the most commonly used forms of yield expression but it takes no account of the compounding effect of income reinvestment. Spreads The difference between the two bonds respective yield curves. Yield curve A graph that plots current bond yields against their time to redemption. 11

12 For more information on Threadneedle and its funds, visit threadneedle.co.uk or speak to your financial adviser. Important information The value of investments and any income is not guaranteed and can go down as well as up and may be affected by exchange rate fluctuations. This means that an investor may not get back the amount invested. The research and analysis included in this document has been produced by Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. Threadneedle Asset Management Limited. Registered in England and Wales, No Registered Office: 60 St Mary Axe, London EC3A 8JQ. Authorised and regulated in the UK by the Financial Services Authority. Threadneedle Investments is a brand name and both the Threadneedle Investments name and logo are trademarks or registered trademarks of the Threadneedle group of companies. threadneedle.co.uk Issued Valid to T11526

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