Bonds 2: “But why is it called fixed income if the return can fluctuate?”

Susan
By Susan June 6, 2012 09:33

Bonds 2: “But why is it called fixed income if the return can fluctuate?”

 

Last year when Irish bonds were downgraded to junk status, their yield suddenly went through the roof and took us on a bit of a rollercoaster. Suddenly it looked like bonds were as volatile as stocks, generating the same kind of excitement – or were they?

 

If bond yields can fluctuate so much so quickly, why on earth are bonds called fixed income?! And if both the maturity date and the coupon of a bond are fixed, what is the variable that can explain those fluctuations?

 

Let’s list a few common questions that come up often about bonds

 

 

“Why is it called fixed income if it can fluctuate?”

 

My answer would be – define “it”? The first “it”, that is, bonds, are called fixed income because a lot of their characteristics are, indeed, fixed when a bond is first issued, never to change again.

 

These would be:

– the face value or par value. Just like bank notes have a face value, bonds have a fixed redemption value: usually 1000 of a given currency denomination, i.e. €1000 in the Irish case.

– the coupon, which is the interest payment that the borrower pays out to the lender at regular intervals. The coupon is expressed as a percentage of face value.

– the maturity date, when the bond is redeemed and capital is returned to the lender.

 

For the period that you hold the bond, you will receive the amount of the coupon, calculated on the face value, every time the borrower pays out interest to the bondholders.

 

This means that you will always receive the same amount of income, since the coupon, and the amount on which the coupon is calculated (the face value), never change.

 

The “it” that can fluctuate, on the other hand, is the price of the bond – and the capital gain that you can make as a result. Price should not be confused with face value: each bond is “worth” €1000, but you might not buy a bond at its face value.

 

You can buy it “at a discount“, when its price is lower than its face value, or “at a premium“, when its price is higher than its face value. If you buy the bond at a discount, you will make a gain when the face value of the bond is redeemed at maturity: if you bought a bond with €100 face value for €87, your capital gain is €13.

 

And yes, sometimes it is an excellent investing decision to buy a bond at a premium, for more than  it’s “worth”…

 

 

“What is the difference between the coupon and the yield?”

 

The yield represents the return that the bond can bring you, whereas the coupon is the  amount of interest that you earn annually or semiannually.

 

The coupon is subject to the terms of the bond, that is, it remains as set in the terms for the whole life of the bond. The coupon could be fixed, as in the example above, or it could be floating if it moves in line with a variable. For example, there are bonds that offer a coupon that changes in line with inflation or the ECB interest rate. But the way it changes with those variables would be decided at issuance and would not be modified.

 

The yield is a function of the varying price of a bond: it calculates your return if you were to buy the bond at that point, factoring in the coupon and the price of the bond. If the price of the bond decreases, the yield increases, and vice versa.

 

This is because the yield is comprised of both the coupon and the capital gain that a bondholder can expect, if they hold the debt security to maturity. If I buy a bond that has a face value of €100 and a 5% coupon bond, at a price of €87, I will get the €5 per annum as well as €13 at the end of the life of the bond, when it is redeemed at par.

 

The yield that is most often quoted is the yield to maturity. This measure of a bond’s return assumes that I hold the bond to maturity: that is, I don’t sell before maturity, but I wait until it is redeemed.

 

The annual yield to maturity factors in the coupon and the portion of the capital gain that I am entitled to for holding that bond. Of course, I won’t get any of that capital until maturity, but the portion of this capital I would be entitled to on a yearly basis is still added into the calculation.

 

Calculating the yield allows you to compare otherwise uncomparable bonds: how do you decide between a 10-year bond with a 5% coupon selling at a discount and a 30-year bond with a 4% coupon selling at a different discount? Calculate their respective yields and you know what return you can expect from each, putting them into an “apples-to-apples” comparison.

 

 

“And why would the price of a bond go down?”

 

Let’s take an example: one bond is issued with a 6% coupon at a certain time, and six months later another bond of the same maturity is issued by the same issuer, but with a 4% coupon.

 

It might be because interest rates have fallen in the meantime: the issuer will take advantage of this to get a lower interest rate on their loan and decrease the cost of borrowing. After all, which would you prefer? Paying back a mortgage with 4% interest, or one with 6% interest?

 

A bond with a lower coupon will provide less regular income than a bond with a higher coupon. Since there are other, higher coupon bonds on the market, buyers will only accept to buy a lower interest coupon at a discount, in order to increase their capital gain.

 

This is why received bonds wisdom says that “Bond prices increase when interest rates decrease, and they decrease when interest rates increase”. Think of it this way: at a given moment, certain bonds on the bond market have, say, a 4% coupon. Suddenly interest rates rise to 6%. This means that new bonds that are issued now will have a coupon higher than 6%, to invite people to buy bonds rather than just save.

 

Indeed, interest rates rising to 6% would mean that retail banks would be able to offer that rate to their clients. And if people can get 6% in their banks, they would need an extra incentive for taking the risk of investing in a bond, instead of just putting money in their savings account. This incentive is called a risk premium and takes the form of an increased return.

 

The slightly older bonds with a 4% coupon suddenly seem less attractive than the newer bonds. So their price will decrease as their risk premium has now contracted. Another way to make sense of that statement would be: “The price of older bonds will increase when the interest rates on newer bonds decrease, and the price of older bonds will decrease when the interest rates on newer bonds increase”.

 

One of the other myriad of reasons that a bond price might go down is if this bond is perceived as riskier.

 

 

“Why do notations by ratings agencies influence the yield of a bond?”

 

Would you buy a Greek bond these days? You would decline, considering the poor credit quality of Greece at the moment. Or perhaps you would only accept to buy it with a high risk premium: that is, a high yield.

 

Talks about the Eurocrisis in the media have revolved a lot about notations by ratings agencies (Standard and Poor’s, Moody’s, Fitch). The work of these agencies consists in regularly issuing an informed opinion of the quality of bonds that are on the market. They will compile a report to let investors know whether issuers of bonds are reliable or whether they might be feared to default on their loans.

 

If a question begins to arise as to whether an  issuer can repay, ratings agencies put this issuer on “negative watch”, which means they are more likely than previously to give this issuer a riskier label… This could take the form of a full blown “credit downgrade”.

 

This means that bonds issued by this institution are perceived as riskier investments. With this extra risk, the price of this issuer’s bonds may fall. As you know now, a lower bond price is reflected in an increased yield, in order to compensate investors for the risk they are taking with a higher return.

 

“But when do I pay attention to the yield, and when do I look at the coupon?”

 

Firstly, it (literally) pays to examine the tax implications of buying bonds. In Ireland, you would pay capital gains tax on the capital gain and income tax on the income. This may lead you to look for coupons over capital gain or vice versa.

 

All in all, the yield is the actual return on investment that you would make if you held that security to maturity. It is therefore an indicator that you would be interested in when considering buying a bond (or trying to find a buyer for the bonds you hold).

 

Now of course if you were planning to sell a bond that you currently own and buy another one to replace it you would also pay a lot of attention to yield.

 

But if you hold on to the bonds you have and have no intention of selling them or buying new ones – if you use bonds as a way to generate income, because you are retired for example -, don’t let yield fluctuations worry you (unless the question of default is a serious concern).

 

You will keep on earning the same coupon throughout the time that you hold the bond, and since the bond will be redeemed at maturity, the capital gain which you have locked in also doesn’t change.

 

This is why, notwithstanding fluctuations, bonds are still called fixed income.

 

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Susan
By Susan June 6, 2012 09:33