What are bonds & how do they work?

A bond is a debt instrument where people or businesses lend money to a government or company for funding needs. In addition to the original bond value, this product has a set term and interest rate.

Companies and Governments use bonds for a variety of funding needs. As such, bonds can have different applications for Investors and Borrowers.

Choosing Bonds as Investments

Bonds can be a valuable part of an investment portfolio. However, unlike cash investments or term deposits, they can be complex. 

Bond Yields and Risk

The return on your investment, or “yield”, reflects the risk of the underlying product. There is a direct relationship between risk and yield, which requires understanding the bond’s quality. 

• If there is any doubt about the ability of the bond issuer to meet their commitments, a higher yield is offered as consideration for the risk.
• The inverse relationship between risk and yield drives the expectation of a much lower interest rate or yield return.
• Without a detailed understanding of the market, looking for the highest available yields may be misleading.
• For example, Federal Government Bonds from a recognised country such as the USA or Australia are considered low-risk and generally return a lower yield.

Using Bond Ratings to Compare Bond Investments

Bond ratings are a useful tool when comparing different product types. Well-resourced ratings agencies conduct research and issue ratings for various classes of Bonds. For example, most people are familiar with Federal and State government-issued bond ratings.

Moody’s, Standard & Poor’s and Fitch are the leading rating agencies that evaluate bonds. Rating agencies play an essential role in the market as they materially impact the price and yield of different bonds. 

Rating tiers fall into “Investment Grade” or “Speculative Grade” according to risk. For example:

How does Australia rate?

For larger bond issuances, there is generally alignment in ratings between agencies. Australia is among only nine countries rated AAA or equivalent by all three major credit rating agencies.

At the State Government level, there are different results. 

• Victoria is rated ‘AA’ by Standard and Poor’s and ‘Aa2’ by Moody’s, the lowest rating of any state in Australia.
• Western Australia and ACT have ‘AAA’ S&P credit ratings.
• NSW, Queensland, South Australia and Tasmania hold ‘AA+’ S&P ratings.  

Moody’s and Standard & Poor’s don’t always agree on a bond’s rank. For example, NSW receives the highest rating from Moody’s (Aaa) and Fitch (AAA) but a lower rating from S&P (AA+). While not unusual, it can be a sign of volatility about the quality of the bond issue.

Investment vs Speculative Bonds

Investment grade bonds are sought by investors who seek a stable income stream and preservation of capital.

Speculative grade bonds are sought for higher returns. They can also be subject to circumstances that lead to a weakened capacity to pay interest and repay principal compared to bonds in higher-rated categories.

Typically, bank-issued bonds don’t go below a rating of BBB/Baa. Ratings below this level signal a higher risk of default, and such bonds must pay higher yields. High-yield bonds are sometimes referred to as “junk bonds”.

Bonds are often considered risk-free and seen as a way to ‘collect interest and cash in at maturity’. This is generally true of investment-grade bonds, but investors should perform their own analysis and grade bonds according to their appetite for risk.

The Price of Bonds – Coupon vs Current Yields

Beyond the basic functionality of bonds as a product, like currency, they also have a robust secondary market and are speculated heavily on by traders.

Coupons Yields

Bonds are offered in portions known as tranches that carry different risk levels. When a tranche is issued, each has a specific quality, maturity, and annual interest rate or “Coupon Yield” that does not change during the bond’s lifespan.

Therefore, the price of bonds and current interest rates have an inverse relationship: 

• When interest rates go up, the prices of existing bonds go down
• When interest rates go down, the prices of existing bonds go up

Current Yields

The formula to calculate Current Yield is:

Current Yield = Annual Coupon Payment​​ (Coupon Yield)
                                                    Bond Price

For a $1,000 bond that receives $40 in annual interest payments, the Coupon Yield is 4.0%. If this is the market or “par” rate, this is said to be trading at 100.

What if the “Current Yield” falls to 3.75%? As a result, bonds yielding 4.0% are now more valuable, so the market bond price goes up. Using a base of 100, the new value is nearly 107.

For investors, the Current Yield matters should you plan to “sell” your bond before maturity. 

Banks, Bonds and Borrowers

Beyond governments and corporations issuing bonds themselves, the bond market (and secondary markets) play a crucial role in determining base funding costs for banks. In turn, this affects what borrowers pay to borrow money.

Funding costs are very complex and can be misleading to summarise briefly. For home loans or small business borrowings, the actual cost is often presented as a simple interest rate (fixed or variable). The actual cost to the lender in reality, is far more volatile.

For larger borrowings, such as commercial or corporate, the effective interest rate is referenced to a base interest rate directly linked to the market.

Understanding Borrowing Costs

Banks package up money for borrowing and investing for terms ranging from 30 days to 10 years. 

• Terms longer than 180 days are referred to as fixed.
• Terms shorter than 180 days are known as floating interest payment periods that ‘rollover’.

An example is Bank Bills. When these mature, they rollover for a further term. The interest rate is then reset at the rate applicable for the next term. The new rate is usually based on an independently determined money market buy rate such as BBSY (Bank Bill Swap Bid Rate).

When investing in bonds or structuring borrowing, important decisions are required based on current and future needs. Always seek advice relevant to your situation.

More Information?

Contact MCP:

P - (03) 9620 2001 or your Finance Partner
E - enquiry@mcpfinancial.com.au

Follow us on Linked IN 

The team at MCP Financial Services has specialised expertise in structuring complex debt arrangements. We can assist with review and restructuring, refinancing and renegotiating.