Martin Hawes on investing in bonds

Martin HawesMartin Hawes
Chair, Summer Investment Committee


Bonds are an investment traded worldwide. The markets where bonds are bought and sold are large, bigger even than sharemarkets. Yet although there are tens of thousands of bonds on issue, many of which are frequently traded, they may not be well understood by many retail investors.

The very word “bond” sounds solid and secure and speaks of a solemn promise - however bonds are not without risk. Bond issuers can default and in any event, the value of a bond can fluctuate. This can mean that if you decide to sell your bond, you may not get all your money back, or as much as you expect even if the bond issuer is not in default.

Let’s take a closer look at bonds. 

A bond is essentially a loan from investors to the bond issuer, which can be a Government, Local Authority, company, or other entity. In return for the investors’ money, the issuer pays an agreed rate of interest for a set time, and repays the amount invested at maturity. 

For example, a company like Contact Energy might issue $100 million of bonds at 4.5% each year with a term of six years. In return for the $100 million invested, Contact Energy pays the interest at agreed periods (typically every three or six months), and at the end of the term (six years) it repays the investors their money. As a retail investor, you could invest for example $10,000 into this bond issue, usually through a manager associated with the bond issue, such as sharebroking firm or a bank.

Like a term deposit, the interest rate is fixed and the bond matures on an agreed date (although bonds are usually for longer periods of time, up to 30 years in some countries). However, unlike term deposits, after the bond is issued there is often a market on which the investors can buy and sell if they do not want to hold the bond to maturity. This is called the secondary market. In some cases these bonds may also be able to be bought and sold on stock exchanges such as the NZX.

Of course, if you plan to hold your bond through to maturity (i.e. for six years), you do not have to think about this secondary market, the company will continue to pay your interest regularly and on maturity will give you back your $10,000 (unless, of course, it defaults on its obligations).

However, if you need to sell your bond after (say) three years you will be subject to the vagaries of the bond market. Like any market, there are ups and downs in prices – this means that investors who want to sell may not get all their money back, or they may make a profit.

Much may have changed over the three years since you first purchased your bond, interest rates may have gone up or down, or the market may have positively or negatively reassessed the credit-worthiness of Contact Energy. And, of course, you no longer have a six year bond – three years have passed and so the new buyer of your bond only has three years to maturity, which may be a plus or a minus! And these are only some of the factors that may affect the value of the bond.

While some retail investors purchase a bond with the intention of holding it through to maturity, there are other investors who look to buy and sell with the intention of making a profit or managing risk. Some retail investors may also need to buy and sell, something may have changed in their lives meaning that they need the cash - or they may see that their bond is trading at a much higher price than the amount they paid for it and so want to take a profit.

Other retail investors may use the secondary market to buy bonds. New bonds are not issued every day (or even every week) and rather than wait for a new bond to be issued, they may choose to buy an existing bond on the secondary market.

The purchase of a bond on the secondary market can be arranged by a sharebroking firm or bank. The market works in a similar way to the sharemarket where buyers and sellers offer to buy and sell bonds rather than shares.

On the secondary market, we see three main things that could influence the value of your bond:

  1. The rise and fall of interest rates. If interest rates have risen so that a new bond similar to your Contact Energy bond now has an interest rate of 5%, other investors won’t pay $10,000 for your bond which yields only 4.5%. Instead, if you want to sell your bond you will have to sell at a lower price (say, $9,800) so that the new investor is reimbursed for the lower-than-market interest rate that the bond pays. Conversely if interest rates have fallen so that 4% is now the prevailing rate, you will be able to sell your bond for more than the $10,000 that you paid for it (perhaps you would get $10,200). 
  2. Over the time of the bond (six years in this case) the issuer’s credit-worthiness may change – something may happen to Contact Energy which means that it’s more or less likely to be able to make the payments due under the bond. Other things being equal, if Contact Energy’s credit-worthiness improves the bond will be worth more, as there is more perceived safety for the investor. However, the converse is also true, a Contact Energy bond would be less valuable if Contact Energy’s credit-worthiness, in general, was assessed to be weaker than when it first offered its bond for sale.
  3. The time remaining until maturity affects the value of a bond. Often, longer-term interest rates are higher than shorter-term rates. The higher interest rate for a longer time to maturity compensates investors for the additional risk that they take when committing money for a long period (the longer the time to maturity the more chance of something adverse happening that could affect the bond, after all, who can accurately predict the future?). In this case (and other things being equal), as the time to maturity decreases, a new investor buying your bond will be happy with a lower interest rate.  

The above is a general outline, but there are many different types of bonds and many variations. In summary, it is important to remember that many bonds are able to be bought and sold in a secondary market, in other words once you have one, you are often able to sell it. However, the price at which you buy or sell it will reflect the current market, which may not necessarily be the same price you paid for the bond. Even though all is well with your bond, the interest is being paid, and there has been no discernible change in the credit-worthiness of the issuer whose bond you own, your bond may still increase or decrease in value. 

Investors may also want to consider investments that initially look like bonds, in that they pay a fixed interest rate for a specified term, but can be converted to equity (shares) in the issuer in certain circumstances. These investments are usually clearly labelled, including terms like convertible, hybrid or equity in their offer documents. They are often more complex and risky than bonds that use terms such as senior and unsubordinated in their offer documents, and may not be suitable for all investors. If you would like to learn more about them (or bonds generally), please talk to your Authorised Financial Adviser.

 

If you are interested in other investor education insights from Martin visit the Media Investor Education page.

Martin Hawes is an Authorised Financial Adviser. This is not a recommendation to buy or sell any financial product and does not take your personal circumstances into account. All opinions reflect our judgement on the date of communication and may change without notice. Past performance is not a reliable guide to future performance. We recommend you take financial advice before making investment decisions. We have prepared this web page in good faith based on information obtained from other sources, but we do not guarantee the accuracy of that information. We do not make any representation or warranty (express or implied) that this web page is accurate, complete, or current and to the maximum extent permitted by law disclaim any liability for loss which may be incurred by any person relying on this web page.