What are bonds and how do they work? Where do bonds trade? How are bonds priced? What’s the “normal” curve? What’s a risk premium? What do bond ratings tell us?
On March 27, Timothy Logan, President of Logan Wealth Management, hosted a webinar covering the fundamentals of the bond market. This presentation was entitled: Understanding the Shrouded World of the Bond Market. A Video of this webinar can be found here – LWM Webinar – Introduction to Bond Markets
What are bonds and how do they work?
Effectively, a bond is an IOU. When you invest in a bond, you’re lending money to a corporation, government, financial institution or other entity. And like any loan, it’s important to focus on three things: how much you’re lending (the principal); when you’ll be repaid (the maturity date) and; how much you’re going to earn? The repayment schedule is known as the “coupon”, or annual interest rate.
In the bond market, another important term is “par” value. This is the full value of a bond upon maturity, expressed as $100. Unlike a GIC, a bond can be bought and sold before its maturity date and may sell for more or less than par value as the yield becomes more or less attractive. For example: you may purchase a bond before its maturity date at a price of $95, in which case you’d pay $95 for a $100 maturity value.
Where do bonds trade?
Unlike stocks, most bonds trade over the counter, which means they trade between financial institutions and not on an exchange. Banks and other financial institutions buy blocks of bonds and hold them in inventory. Financial advisers can buy from this inventory or send bond traders out into the market to look for a bond issue. A bond trader will call other bond traders or financial institutions to source a buyer or seller.
Building a bond price – the normal curve
On the chart below, the left axis represents interest rates. The bottom axis represents the number of months to maturity. The shape of this curve is called the “normal” curve because normally interest rates increase as the maturity date moves further out.
Figure 1 – The Normal Yield Curve
In this example, the yield after one month is approximately 1.7%. At 12 months, it increases to 2%. At 60 months, or five years, it reaches 2.6% and at 10 years, it hits 2.8%. Finally, at 30 years, the interest rate exceeds 3%. As the term increases on the normal curve, the rate of interest increases as well. So, the longer you lock in your investment, the higher the rate of return.
Building a bond price – the risk premium
A “risk premium” is the return you can expect when you take on increased risk in the bond market. This risk premium is also called the “spread”.
Figure 2 – The Spread
As you can see on this chart, at the 60-month mark, the rate of return for lower quality corporate bonds is 0.5% higher than the rate of return for higher quality corporate bonds and a full one percent higher than the current rate of return for risk free bonds. The difference in the rate of return reflects the quality of the investment. The higher the risk, the greater the spread.
What do bond ratings tell us?
How do we categorize bonds? We don’t use jargon like “blue chip bonds” or “super scary bonds” or “pretty solid bonds”. Instead, we have a system established by rating agencies that rate these investments according to industry accepted standards.
Figure 3 – Bond Ratings
The highest bond rating is “AAA”, which means that the chance of these bonds defaulting is very low. Examples include: bonds issued by the Government of Canada and the Province of British Columbia. At the same time, U.K. bonds are rated “AA”, which is still very high, but probably affected by uncertainty surrounding Brexit. Where does the province of Ontario fit in? Its bonds currently have a single “A” rating, while Bell Canada’s bonds are in the “BBB” category. All the way down near the bottom, in the default category, are countries such as Venezuela.
When we talk about the risk of default, we’re referring to the chance of not receiving timely interest payments. In this case, it is possible to incur a partial or total loss of your investment. And since the likelihood of this happening increases with an issuer’s risk profile, the rate of return is also higher.
Figure 4 – Investment Grade versus Non-Investment Grade Bonds
As illustrated in Figure 4, “AAA” bonds do not default. They have demonstrated a long, historical pattern of not defaulting. However, “BBB” bonds have performed differently, demonstrating an average 2% default rate over a recent 10-year period. Over the same time, “BB” bonds have demonstrated an average default rate of 7%.
What to expect in part two of this presentation
In the first part of this webinar, we’ve defined key terms used to describe the bond market and its functions. We’ve also looked at how bonds are assessed and rated. In the second part of this presentation, we will address how changes in interest rates affect bond prices. We’ll also cover some tax considerations and provide an overall assessment of the challenges associated with the bond market as an investment vehicle.
Disclaimer: Please note that the information presented here is intended as general information only. It reflects the thoughts and opinions of Logan Wealth Management and should not be construed as investment advice. Please consult your adviser to determine whether this information is applicable to your personal situation.
