A 2 Minute Crash Course In Bonds
Just like all forms of debt based assets bonds act as a form of IOU whereby the investor lends money to the issuer who agrees to pay back that initial investment at some point in the future in addition to regular interest payment over the term of the investment. That initial investment made by the investor that is to be repaid at the end of the loan term is referred to as the bonds face value (Usually $100). The regular interest payment is determined by the bonds coupon rate which is the percentage of the bonds face value that it will pay out as interest to investors. Australian and American bonds usually pay interest every half year so an Australian treasury bond with a $100 face value and a coupon rate of 4% would make a half yearly interest payment of $2.00 twice every year.
However it’s not just governments who issue bonds, corporate bonds are also issued by major listed companies in order to raise capital. Corporate bonds generally pay higher coupon rates in order to reflect the higher risk associated with lending money to a corporation as opposed to lending money to a government which essentially has zero credit risk. However there is still a lot of variation in the coupon rate of various corporate bonds – part of which can be explained by where these bonds are placed in the company’s capital structure. Senior Secured Bonds are the least risky corporate bond as they have first claim over the issuer's assets in the event of liquidation. Senior Unsecured Bonds then have second claim to the company’s assets, Subordinated Debt has third claim then Capital notes are the final debtholders with a claim to any residual assets. As you might imagine the lower down on this list you fall the higher the coupon rate the bond will pay in order to compensate the investor for taking on the additional risk.
However bonds are not only exposed to the credit risk of the issuer, most importantly they are also exposed to movements in interest rates. To illustrate this point let’s take a very basic example, Let's assume prevailing interest rates for government bonds are currently 3%, so the Australian government issues new Treasury Bonds with a 3% coupon rate and a $100 face value. A month after the issue of these bonds prevailing interest rates move up to 3.5% and the government issues new Treasury Bonds with a coupon rate of 3.5% and a $100 face value. What happens to the price of the government bonds with the 3% yield? Well logically the price would decrease as there’s no reason why a rational investor would purchase a bond with a coupon rate of 3% when they could buy the same bond but with a 3.5% coupon rate for the same price. Clearly then in a rising interest rate environment such as the one that appears to be developing in the US is bad news for bond prices. However it should be noted that by simply holding a bond to maturity investors can eliminate this capital risk as bonds will always redeem for it’s face value at maturity no matter what the market price is.
HarbourSide Capital is an Australian provider of Managed Discretionary Accounts.
HarbourSide Capital Pty Ltd (ACN: 166 765 537) is a Corporate Authorised Representative (CAR No. 448907) of HLK Group Pty Ltd (ACN: 161 284 500) which holds an Australian Financial Services Licence (AFSL no. 435746). Any information or advice contained on this material is general in nature and has been prepared without taking into account your objectives, financial situation or needs.Source: ASX