Private Clients

Bonds

Asset Classes: Fixed Income

What is fixed income?

As the largest securities market in the world, the bond market provides investors with virtually limitless investment options. Seasoned investors should be familiar with most aspects of the market, but as the number of new products entering the market grows, even a bond expert is challenged to keep pace.

Put simply, a bond is a loan that a bond purchaser or bondholder makes to a bond issuer. Governments, corporations, and municipalities issue bonds when they need capital. If you buy a government bond, you’re essentially lending money to the government. If you buy a corporate bond, you’re lending the corporation money. Like a loan, a bond pays interest periodically and repays the principal at a stated time/date.

The price of most bonds is set so that face value/par value per unit is repaid on the maturity date. Between the issue date and the maturity/redemption date the bond price can vary, depending on multiple factors. One such factor is the interest rate at that time. If, for example, the bond pays an annual coupon of 5% and interest rates are lower than this, investors will find the bond income stream attractive and will be prepared to pay a higher price for it.

 

Bond maturity refers to the specific future date on which the principal invested will be repaid. Generally, bond maturities range from 1 year to 30 years and are frequently categorised as:

 

Short-term bonds: Maturing in less than 5 Years

Medium-term bonds: Maturing in 5 – 10 years

Long-term bonds: Maturing in more than 10 years

Risk & return: Bonds

The risk profile for government bonds is considered lower than equities. Every bond does carry some element of risk, in that the issuer may ‘default’ or fail to repay the bond to the investor.

However, there are protections in place. Independent credit rating agencies assess the default risk of all bonds, so, for example, an issuer with a higher credit rating will pay a lower interest rate on the bond.

Investors who purchase bonds with low credit ratings can potentially earn higher returns but they’ll bear a heightened risk of default.

How does the market value bonds?

Here’s an example: The Irish 0.2% 05/15/2027 bond is priced on the spread to German bond yield when it was issued in 2020. The amount outstanding is 7.25bn and its rating is AA-.

 

The ALLQ Bloomberg screen is used for publishing Irish Government bond prices by all Irish bond dealers, and Bloomberg takes an average of the bid/offer spread and creates an indicative bid price and offer price.

Typical liquidity for fixed income

Irish Government bonds are traded on a T+2 settlement basis. This means that the settlement cycle, or the difference between the trade date and settlement date, is two days for Euro bonds. The settlement cycle for Gilts and US treasuries is on a T+1 basis. In general, the length of the settlement cycle is important for bonds, because the greater the time period between trade and settlement, the greater the risk of failure of the trade, especially in a volatile market.

 

The market depth or liquidity of a bond is determined by how easily a bond can be bought or sold in the market. The bid/offer spread of a bond is commonly used as the measure of this liquidity, i.e., a wider spread would be interpreted as the market being less liquid.

Typical Income from fixed income

Here’s a worked example of a 100k investment into an Irish 4-year bond.

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