What are bonds, what bonds are there and what are the risks?
G.R. krahmer
The History of Bonds
The Dutch Republic was the first state to finance its debt with bonds when it adopted bonds issued by the municipality of Amsterdam in 1517. The average interest on those bonds hovered around 20%. The first official government bond issued by a country’s government was by the Bank of England in 1694 to raise money for a war against France. Later, governments in Europe began to copy each other and began issuing government bonds to fund wars and make other government expenditures. During the American Revolution, the United States government issued bonds that gave them $27 million dollars to finance the war.
What are bonds?
A bond can best be described as a debt instrument or part of a loan from an investor to a company, government organization or country. In exchange for that loan, you receive a certain interest rate every year. This can be a fixed interest rate or variable interest rate. This is also called the coupon interest.
Companies or countries issue bonds to borrow money and make certain investments with that borrowed money. A bond can have a term of a few months, but also ten or twenty years. Government bonds and corporate bonds are the best-known types. You can trade bonds on the stock exchange just like shares. You can also trade them using ETFs or index funds. By purchasing these ETFs or index funds you immediately ensure diversification in your portfolio.
What are government bonds?
A government bond is a loan from an investor to a country or government. Because government bonds are generally less risky than corporate bonds, they often yield a lower interest rate than corporate bonds. However, this is not always the case. For example, bonds from countries with a poor financial position are riskier than those from countries with a strong financial position and can therefore sometimes still pay a higher interest rate.
What are corporate bonds?
A corporate bond is a loan from an investor to a company. In general, corporate bonds are riskier than government bonds. That is not surprising, because a country is less likely to go bankrupt than a company. You are often rewarded for that higher risk, because corporate bonds often provide a slightly higher return, unlike government bonds.
How do bonds actually work?
Just like shares, bonds can also be traded on the stock exchange and their value can fluctuate. However, the behavior of bonds shows a completely different pattern than shares. That is why bonds belong to a different investment category.
- The price of bonds rises when interest rates fall and vice versa. Prices and interest rates therefore move in opposite directions.
- The fluctuations of bonds (due to changing interest rates) become smaller as the term becomes shorter.
- Government bonds from solid institutions such as the Dutch State or the US Treasury often offer a lower interest rate than more vulnerable institutions such as a company or emerging country.
- In general, the longer the term, the higher the interest.
| Impact of interest rate changes | ||||||
| Your purchased bond | ||||||
| price | principal amount | coupon | ||||
| €1,000 | €1,000 | 5% | ||||
| 1% decrease in interest rates | 1% increase in interest rates | |||||
| Your purchased bond | Your purchased bond | |||||
| price | principal amount | coupon | price | principal amount | coupon | |
| €1,050 | €1,000 | 5% | €950 | €1,000 | 5% | |
| New Bonds | New Bonds | |||||
| price | principal amount | coupon | price | principal amount | coupon | |
| €1,000 | €1,000 | 4% | €1,000 | €1,000 | 6% | |
How can bonds increase or decrease in value?
The value of bonds depends on a number of factors. Firstly, the interest rate.
The interest rate policy is a determining factor for the price. If a central bank keeps interest rates low and is expected to do so for the entire term, alternative investment options can look more attractive when prices rise. This can cause bondholders to sell their position, which lowers the price. The price of bonds therefore rises when interest rates fall and vice versa. We can best explain this with an example.
Suppose you bought a bond with a coupon rate of 3% and the central bank decides that the interest rate will fall by 1%. The result is that the new bonds will then pay 1% lower interest and will therefore have a coupon interest of 2%. Investors will now prefer to buy your old bond with the higher interest rate, and therefore the market value of your purchased bond will increase.
The opposite happens when interest rates rise. The market value of the bond therefore decreases. In this case, your bond has now no longer become as attractive to other investors, because the new bonds pay a higher interest rate. And that means that the price of your bond falls. The chance that something will happen to the interest rate is greater with a bond with a longer term than with a bond with a shorter term, such as 1 year. This is why bonds with a short term are often slightly safer than those with a longer term. At the same time, a long-term bond also offers a greater chance of a higher return.
“In general, we would expect an index exposure to deliver the “market return.” However, many iShares bond ETFs have competitive performance relative to other ETFs and mutual funds.”
Investing through ETFs and index funds ensures that you never reach the end of a term
Different bond maturities
Government bonds come in different maturities and in general, long-term bonds pay more interest than short-term ones. On the other hand, long-term bonds are somewhat riskier. The term of the bonds is important and can play a different role within a portfolio. That is why we can see short-term bonds as a different subcategory than, for example, long-term bonds.
There is a greater chance that something will happen with a bond with a term of 10 years than with a bond with a term of 1 year. That is why short-term bonds are often safer than long-term ones. At the same time, a long-term bond also offers a greater chance of a higher return. Because we invest via ETFs and index funds, you do not have to worry about whether the term expires, and you can expect the average return of the chosen bond index.
You will often hear terms such as short-term bonds and treasury bonds. Treasury means it comes from the United States, and short or long has to do with the maturities of the bonds. It is generally assumed that the basic terms are as follows:
– Short-term bonds are short-term bonds with a short term (1-3 years)
- – Intermediate-term bonds, are medium-term (if that is a word) bonds with a medium term (5-10 years)
- – Long-term bonds are long-term bonds with a long term (15 years and longer) What is the risk of investing in bonds? Investing in bonds seems to be a safe investment. You lend your money to a company or government, where you receive a certain interest every year, and you get your money back at the end of the term. Although bonds are generally a lot less risky than shares, investing in them also entails risk. Companies or countries cannot always meet their obligations, and bonds can also rise and fall in value. Bonds have different risks, and the extent of those risks depends on a number of factors. For example, as mentioned earlier, government bonds from most Western countries are relatively safe, but also have lower interest rates. Corporate bonds often deliver
more, but this often involves a higher risk. But in addition to the risks mentioned earlier, there are a few other risks that play a role. Inflation risk Inflation plays a major role in bond returns. Inflation causes the purchasing power of your money to decrease over time. With the money from a bond, you can therefore buy less over time. In short, the purchasing power of your money decreases when holding a bond and paying it off. This is always a risk with a normal bond. You can protect yourself against this by, in addition to normal bonds, special inflation-related bonds to buy. These are bonds that are adjusted for inflation so that you are almost certain that you will retain your purchasing power. Debtor risk This is the risk that the bond issuer cannot pay you back. For example, if a company goes bankrupt, there is a chance that you will not receive any interest or that you will not even see the entire amount again. In general, corporate bonds are riskier than government bonds. After all, a company has a greater risk of going bankrupt than a country. You can reduce this risk by purchasing broadly diversified ETFs and index funds with, for example, a lot of government bonds from various Western countries. Currency risk Bonds are available in a variety of different currencies. For example, there are bonds that are issued in euros, but bonds in dollars, pounds and yen are also for sale. If you buy bonds in a different currency than the money you spend, you run an exchange rate risk. If the interest is paid in dollars, and you pay and live in euros, and the exchange rate of the dollar falls, you have less to spend. Suppose you have a bond in 1000 dollars and the rate of the dollar falls, you will receive 1000 dollars back, but because the rate has fallen you now get fewer euros in return / you need more dollars for the same euro. This can also work to your advantage, but it is
something to take into account. You can reduce this risk by diversifying across different currencies or by purchasing special ETFs and index funds that are covered/hedged in Euros.
Government bonds or Corporate bonds?
For many investors, bonds are a kind of counterpart to shares. In times of crisis, shares can fall sharply in value, while bonds often remain stable or rise. That’s why you can add government bonds to your portfolio if you want to invest more safely. The reason why government bonds ensure that you have fewer fluctuations in your portfolio is because they have a low correlation with shares over the long term. If you look at the past 30 years, you will see that long-term government bonds have had a fairly reliable negative correlation with equities. This is not the case with corporate bonds.
Because government bonds are less strongly correlated with shares than corporate bonds, you will bear less risk in times of a stock crisis if you use government bonds.
It is important to mention that this low correlation becomes even more apparent when there is unrest in the market. This is due to ‘running for your life‘ effect where investors flee to bonds, mainly government bonds, when stocks fall. This causes a price increase in government bond prices. If you look at the chart below, during the 2008 crisis, you saw that when stocks had fallen by 37%, intermediate-term government bonds (with maturity between 5–10 years) had risen by 13%. This while corporate bonds had fallen by 21%.
The 2008 crisis also showed us that corporate bonds run a major liquidity risk during an equity crisis, for which you as an investor are not compensated. It showed that equity risk and debt risk are linked, and that corporate bonds do not do their job when you need them. So that’s when stocks crash. This risk is much lower in the case of government bonds, because the government guarantees them. Taking all this together, you could say that a portfolio of government bonds will most likely outperform a portfolio of corporate bonds during a crisis.
How do you invest in bonds?
You can buy bonds separately or through an investment fund or ETF that invests in bonds. These trackers have the advantage that you can purchase a wide spread of bonds with 1 or 2 transactions. You buy a share in an investment fund, often from a few tens of euros each. This convenience is offset by fund costs, but they do not have to be high. Certainly not if you go for cheap index-tracking funds, which can be purchased from around 0.15% in fund costs per year.
Spread
Although less important than option 1 (buying bonds yourself), it is advisable to ensure sufficient diversification when choosing investment funds. For example, for many investors it is not wise to only buy high-risk bonds (also called high yield). Or to invest only in one region.
Are you aware of the risks?
Do you realize that investing in bonds is not risk-free. For example, a rise in interest rates, which are currently historically low, could deal a major blow to bondholders. In addition, there are other risks, such as the risk that the issuing institution cannot meet its obligations (debtor risk).
Conclusion
So if we look at bonds, we can say that corporate bonds yield slightly more over the long term, but that is because of the extra risks, which government bonds do not suffer from. Keep in mind that you are paying for the potentially higher returns with greater fluctuations and more risk. The whole reason for putting bonds in a well-diversified portfolio is usually to reduce risk and reduce fluctuations. We know that government bonds are better at diversifying than corporate bonds in an equity portfolio. In addition, corporate bonds tend to perform poorly when you need them. So because government bonds are less strongly correlated with equities than corporate bonds, you will bear less risk in times of a stock market crisis if you use government bonds. A cheap, broadly diversified index fund or ETF with government bonds from Western countries could at least make your portfolio a lot less risky.
