The price of a bond moves in the opposite direction of the change in interest rates
By Colls Ndlovu
The arguments presented here are already covered in my book entitled, “Bonds and the Bond Markets”, (pictured).
Recently, the government of Zimbabwe announced that it was going to be issuing an international US dollar denominated sovereign bond to raise money to compensate white farmers whose farms were arbitrarily expropriated during the chaotic land reform program.
The potential size of this bond is rumoured to be in the neighbourhood of US$3.5 billion.
Bonds are financial instruments that have become ubiquitous to ordinary people in general. Phrases like bond markets, bond prices and bond yields are very common even to the most disinterested follower of financial news on television or print.
A key characteristic of a bond is its issuer. Different classes of bond issuers have differences in terms of credit quality, risk and numerous other related factors. Two key issuers spring to mind: government (sovereign) issuers and corporate issuers. Government issuers issue government bonds while corporate issuers issue corporate bonds.
Among government issuers, the most important one is the US treasuries, that is to say, bonds issued by the US government. Corporate bonds as has already been highlighted are issued by companies usually to raise money for their various corporate activities. Governments also issue bonds to raise money to fund their numerous programs.
It follows therefore that bonds are debt instruments. The issuer of a bond owes money to those who would have invested in that bond. Arising from the foregoing background information, the key aspects of bonds will be discussed.
The term-to-maturity, that is to say, the number of years until the maturity (expiry) of the bond is a key feature of a bond. The term to maturity is therefore the day the bond will cease or the day the borrower (issuer) will pay off the remaining debt of the bond. Technically the term “maturity” refers to the day the bond will be paid off.
The maturity is very important because it shows the expected lifespan of the bond. This is key information for investors because some investors are short term oriented while others have longer term strategies. The yield on a bond is dependent on the term to maturity.
The longer the maturity, the higher the yield and vice-versa. The effect of maturity on the yield depends on the shape of the yields curve, that is, the term structure of interest rates. The volatility of the price of a bond is correlated with its maturity.
The longer the maturity, the higher is the volatility. The obverse of this statement is also correct, that is, the shorter the maturity the lower the volatility. Consequently, changes in yields exert more pressure on the prices of longer maturity bonds than shorter maturity ones.
Moreover, some bonds have clauses that allow for modification or variation of their maturity profiles. An investor in bonds needs to be wary of these as they bring newer risks with them. By way of an example, some bonds have call privileges which allow the issuer of a bond to redeem (pay off) the bond earlier than scheduled.
Typically, bonds issued by governments maturing within one year are called treasury bills and are deemed to be less risk than longer term bonds called treasury bonds. This also depends on the quality of the issuing government.
The coupon of a bond is the periodic interest paid by the issuer of the bond to the investors in that bond. The coupon is always cited alongside the maturity on the quotation of a bond. In the US, coupon payments are made twice a year. In Europe they are made once a year.
Some bonds have fixed coupons (hence the term fixed income), others are floating rate bonds, while others are adjustable rate bonds, inter alia.
Risky, high yield coupon corporate bonds are called junk bonds. The term “junk bonds” also applies to sovereign bonds that have been downgraded below investment grade.
Some bonds can be callable through refunding provisions. If the bond indenture (contract) contains a call feature then it means the issuer of such a bond can recall it and repay it partially or in full.
In contradistinction, non-callable bonds are called bullet bonds. Convertible bonds are bonds that can be converted to stock in the issuing firm. This results in a situation where the investor ends up becoming a shareholder rather than a bondholder.
Mortgage-backed securities are instruments whose cashflows depend on the cashflows of an underlying pool of mortgages. Mortgage is itself the pledge of a property against debt on that same property.
The mortgage gives the lender the right to seize the property in the event that the borrower fails to pay the amounts owed as they become due. Asset-backed-securities are securities that are collateralised by assets that are not necessarily mortgage property.
Investment in bonds is always futuristic. There is always a consideration of the term to maturity. That gives rise to the importance of the future value of money.
pv=fv(1 divided by (1+i)^n)
Consequently, the future value of a given amount of money is usually calculated by using a formula similar to the one used to calculate compound interest which includes, principal, interest rate and the time period as in fv=p(1+i)^n.
With “p” being the principal amount. While the present value of an amount to be received in the future is calculated as follows: pv=fv(1 divided by (1+i)^n). With “n” being the number of periods.
This brings us to the important subject of the price of a bond. The price of a bond is equal to the present value of the expected future cashflows.
The required yield to discount future cashflows is offered by comparable bonds. The yield to maturity is the most commonly used yield for discounting future cashflows.
So typically at maturity, the bondholder receives the last installment, the last coupon and also the interest on interest. Through the yield to maturity, the assumption is that interests earned are reinvested at the same yield to maturity.
Investment in bonds invariably comes with an array of risks to the investor. The price of a bond has an inverse relationship with the interest rate on that bond. The price of a bond moves in the opposite direction of the change in interest rates. That is to say, when interest rate increases, the price of a bond decreases.
pv=fv(1 divided by (1+i)^n)
The inverse of this statement is also true. This interest rate risk affects the investor who may have to sell his bond before maturity. If interest rates have risen, the value of the bond could be down hence the investor would suffer a capital loss should he decide to sell his bond. But if held to maturity, that risk is eliminated.
Reinvestment risk arises from the reinvestment of cashflows received from a bond (usually called interest-on-interest). Typically it is a risk that interest rates would fall hence receiving lower interest rate returns.
Credit risk (default risk) refers to the possibility of default by the issuer of a bond thereby imperiling the investor. The credit profile of an issuer is therefore very important in making decisions relating to whether or not to invest.
Inflation risk has a negative repercussion on returns from a bond. If an investor is receiving yields on a bond at 5 percent while inflation rate is 8 percent, in real terms, on a risk adjusted return basis, the investor is losing 3 percent on the bond.
Liquidity risk (marketability risk) involves the potential sellability of a bond. If a bond is likely to sold instantaneously if so required then it has less liquidity risk. But if a bond takes ages to sell then it is deemed to expose the investor or bond holder to liquidity risk.
Currency risk (exchange rate risk) is another potential risk that affects bonds. Depending on which currency the bond is denominated in, converting that currency to, say, a local currency or to the US dollar could pose exchange rate risk to the investor.
On this point, it is instructive to note that the proposed Zimbabwean government bond for farmers will be issued in US dollars specifically to mitigate the currency risk.
Bonds are also subject to volatility risk. Increases in interest rates are usually volatile. Where options or callability of bonds are concerned, this has a greater effect on the value of such bonds.
High volatility in interest rates increases the price of a bond and vice-versa. Legal risk arises when the possibility of any legal action or political action has an adverse effect on the bond.
This could be a moratorium on bond repayments declared by a government. The government of Argentina recently reached a compromise restructuring its bonds worth about US$65 billion with its creditors. That is a form of default and it is a huge risk for bond investors.
Colls Ndlovu, a currency expert, is an award-winning economist and central banker, and is the inventor of the NCX Currency Index. He can be contacted on firstname.lastname@example.org
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