Bonds explained: part 2

Bonds form a significant part of many investment portfolios and can often make up the majority of holdings in some lower risk portfolios, yet many investors know little about them.

At Schroders Personal Wealth we believe it’s important for people to be as informed as possible about the investments they hold. So we have written a three-part educational series that explains bonds in as simple language as possible.

The series is written in a Q&A format and attempts to cut through the jargon to help you understand what bonds are and how they work. This second part builds on Part 1 and covers why some bonds are riskier than others as well as the more complex areas of bond spreads and yield curves.

Interested readers may benefit from rereading the sections on bond spreads and yield curves until the concepts become clear. This may not be easy but we hope it will be rewarding. After all, understanding bonds is an achievement in itself. So why not just take a deep breath and go for it!

Last time you outlined what a bond is, why bonds are considered less risky than shares and how they’re affected by interest rates. I’d now like to know why some bonds are higher risk than others.

It’s mainly down to the riskiness of the bond issuer. Government bonds issued by developed nations are generally considered extremely low risk, but they also offer low rates of interest. In contrast you can get far higher yields from the higher risk variety of corporate bonds, known, unsurprisingly, as ‘high yield’ bonds.

How can you assess how risky bonds are?

Bond ratings agencies can help here. Regarding government bonds, these agencies don’t rate the bonds themselves but the countries. They give a country a rating based on its perceived creditworthiness. Higher rated countries are classed as ‘investment grade’, lower rated countries are classed as ‘speculative grade’, and there are several different ranks of investment grade and speculative grade countries.

Bond ratings agencies similarly rate corporate bonds, dividing them into ‘investment grade’ and ‘non-investment grade’ categories according to their creditworthiness. Once again, there are several different ranks of investment grade and non-investment grade corporate bonds.

So how do ratings agencies assess creditworthiness?

In the case of countries they consider a range of factors, including export revenue and the import ratio. The import ratio compares a country’s total imports with its total foreign exchange reserves. Foreign exchange reserves are central bank holdings priced in foreign currencies, such as foreign government bonds and foreign currencies themselves.

And for corporate bonds?

The ratings agencies analyse company accounts and consider measures of indebtedness and profitability. They consider factors concerning the industry the company operates in. And they evaluate how economic and political factors can affect a company’s creditworthiness.

Do ratings agencies indicate whether or not a bond is good value?

No. These agencies assess the creditworthiness of countries and companies. But they don’t assess whether their bonds are under or overpriced. Stock markets do that!

Generally speaking, though, bonds with lower credit ratings have higher yields than those with higher credit ratings. These higher yields are a reward to investors for the higher risk they are taking.

So what sorts of things do investors consider when assessing the value of a bond?

They could start by looking at a bond’s spread.

What’s that?

It’s the difference in yield between two bonds. Spreads are often measured against US government bonds, known as Treasury bills, or T-Bills.

If a T-Bill yields 5 percent a year and a corporate bond yields 6 percent, then the spread is 1 percent.

But bond specialists usually talk in terms of ‘basis points’, which are hundredths of a percent. So they would in this case describe the spread as being 100 basis points.

Are spreads fixed forever?

No. They vary in line with market forces. When markets become nervous, investors often seek the safety of government bonds. This can lead the prices of T-Bills to rise and their yields to fall. If this happened, the spread between the corporate bond and the T-Bill in this example could widen from 100 basis points to, say, 120 basis points. This is known as spread expansion.

On the other hand, if the market became more confident, then investors might be more attracted to the higher risk, corporate bond than the safer T-Bill. That could lead the price of the corporate bond to rise and its yield to fall. In this case, the spread between the corporate bond and the T-Bill could narrow from 100 basis points to, say, 80 basis points, which is called spread compression.

But I’ve heard of different kinds of T-Bills, such as two-year T-Bills and 10-year T-Bills. Which T-Bill are you talking about in this example?

Good question! To be honest I haven’t been that specific in this example. Just to clarify: a two-year T-Bill has two years to run until it expires and a 10-year T-Bill has 10 years to run until it expires. When comparing the spread of a T-Bill with that of another bond, it’s important to ensure they have the same period until they expire. Otherwise you’re not comparing like with like.

Why’s that?

Let’s say the corporate bond has a one-year expiry date or, using the correct terminology, it has a one-year time (or term) to maturity. And let’s say the T-Bill has 10 years to maturity.

Let’s also say markets expect US interest rates to come down sharply, but not until two years’ time. In this case, the one-year corporate bond would be unaffected by the expected rate cuts, because it would have expired before the cuts happened. But the 10-year T-Bill could rise in price in anticipation of future rate cuts.

To get a fairer idea of the spread between these bonds you’d need to ensure the corporate bond and the T-Bill both have the same time to maturity. In this case the term of the T-Bill would need to be one year, in order to match that of the corporate bond.

Does this also mean a one-year T-Bill could have a higher yield than a ten-year T-Bill?

Yes, it does. In general, when US rates are expected to fall steadily in the future, then yields on T-Bills with longer times to maturity (‘long dated’ bonds) will be lower than T-Bills with shorter times to maturity (‘short dated’ bonds).

This is known as an inverted yield curve, as the curve would slope downwards on a chart that plotted yields against times to maturity. Inverted yield curves are relatively rare and considered a sign of an impending recession. With a ‘normal’ yield curve, the curve slopes upwards in expectation of economic expansion, while a ‘flat’ yield curve indicates economic uncertainty.

So I was right all along: bonds are really complex!

Well the relationship between bond yield curves and the performance of the economy is quite complex. But you don’t need to understand this relationship to understand what bonds are.

I hope I’ve explained bond risk and spreads clearly and that you’ve now understood the basics of yield curves. Next time we’ll go through bond duration, which really is quite complex!

Thanks again. I’m looking forward to the challenge!