I was visiting a friend of mine a few days ago and she showed me a suggested investment strategy offered by her bank. She asked me to have a look and voice an opinion.
She is slightly risk averse as this is her retirement money.
The suggested investment was a mutual fund owning government bonds with a maturity of 20-30 years. The bank suggested that if she leverages this investment her returns could be very attractive.
It is true that the fund has had good performance in the past, and was not very volatile. However, this is where we come to the terminology “past returns are not a guarantee of future returns.”
So, I decided to sit down and explain the way bond markets work. We have had 30 years of declining interest rates, as such the only way for bonds to go, were up, a continual price increase with declining interest rates. We are now already in negative yields and if you were to buy bonds now or invest in a bond fund it would be in the hope of capital appreciation and not yield (interest income). I saw a blank look on her face, so I decided to do some basic explaining how the bond market works.
I wanted to explain the terms coupon, yield and yield to maturity and explain how the interest rate moves affect bond prices.
For the sake of simplicity, I decided to start with simple explanations about what these terms are:
Bonds: governments finance deficits by issuing Bonds. These are none other than an I.O.U. (Promise) that the government will pay you interest and a return of your investment if you lend them money. This will have a fixed interest rate and duration.
Coupon: The interest paid on a bond expressed as a percentage of the face value. I.e. the bond is priced at 100, the interest paid is 7 so the yield is 7%
But bonds prices go up and down and rarely would stay at the price of 100.
We refer to this 7% as the “nominal yield”
Yield: Current yield = nominal yield/market value of the bond.
I.e. The bond is trading at 90 and you are getting 7 coupon, then the yield would be 7/90 = 7.8%
However, the bond trading at 90 would go to 100 at maturity. As such you would receive the coupon of 7 plus an annual growth to 100. This is referred to as Yield to Maturity.
Yield to Maturity: This is the total return expected on a bond if held to maturity. This is important as this is the true yield and value that you are getting.
Here the calculation gets a little more complicated as it assumes the coupon is reinvested.
To keep things simple, we will assume that the bond is trading at
- It has a 7% coupon
- and this bond will mature in 20 years.
- This will create a rising value of the bond from 90 to 100.
- Then the Yield to Maturity is 8.02%
The bond may be expressed as ABC Corporation 7% Dec 30 2028 price 90
The 7% reflects the interest based on a price of 100. The date is when the bond matures and the price is the market price.
- You have a 7% coupon
- The yield is 7.8%
- The yield to maturity is 8.02%
We have seen that the price of the bond fluctuates, and this affects the yield and yield to maturity.
To understand how the price is set, it is compared to the current yield in the market plus a certain amount of risk premium.
I.e. Government bonds have a lower yield than a corporate, lower grade corporate bonds have higher yields to compensate for the additional risk.
Let’s now look at that suggested low risk strategy from this bank.
They suggested buying a fund (which has internal costs of about 0.8%), leveraging it by borrowing money and buying more.
Now we have been in a 30 year declining interest rates scenario, where the yields have gone from 18% down to in many cases zero. We are in bubble territory, it could stay like this for years, but it is still a bubble. The only way this fund can continue to create growth is if the yields keep moving further into negative interest rates. This would have to be substantial to cover the cost of the fund, the borrowing costs and any other commission and fees applied.
Let’s look at the effect of a 1% interest rate movement on a 30 year government bond. Example if interest rates go up, bonds go down. If interest rates go down then bonds go up.
The longer the maturity date the greater the price movement on the bonds. The greater the profit or the bigger the loss.
If the interest rates were to fall by 1% then the value of the bond increases by 19.6%. This explains why for the last 30 years we have seen strong growth in the bond market.
If you believe that the negative or near negative yields will go down further, then prices will continue to rise. However, many people believe we are in bubble territory and this bubble will burst at some stage. In the UK the Prime Minister has said that the wealthy have benefited from low interest rates, but savers and pensioners have suffered. This may be an indication that she is thinking of reversing interest rates. Inflation is due to rise in the UK due to the falling pound, this will also put pressure on raising rates.
We know that if interest rates fell by 1% then we could expect to see a value of the bond rise by 19.6% however if the opposite happened and the rates rose by 1% then the value of the bonds would drop by 20%.
Think of this, a so called low risk investment can easily suffer a 20% loss by a mere 1% interest rate increase, and if your portfolio was leveraged two times, then the losses would be 40%
Be wary of the bond market. It has more risk than most people expect.
If you have any questions, please contact Gordon Robertson