SIMON BROWN: Everything you need to know about bonds
US strategist James Carville famously remarked that he’d like to be reincarnated as the bond market ‘because you can intimidate everybody’. But you don’t have to be intimidated by the jargon of the world’s biggest asset class
Whenever I write about bonds I get a flurry of confused e-mails asking for details of the intricacies of the bond market. For starters: what is the difference between the primary and secondary market? What the heck is a coupon? What’s with the oft-repeated phrase “yield up price down” and “yield down price up”?
So this week I’ll try to make you a bond guru by explaining exactly how they work, and all the jargon involved.
First: the difference between the primary and secondary market. If the government issues a bond and I buy it from them this is the primary market. A bond yielding 10% means my R1,000 will earn me R100 a year from the government and at the end of the term I get my R1,000 back. The local RSA Retail Savings Bonds are exactly this.
If, however, I buy a bond in the bond market, then we’re talking about the secondary market, and the key thing to consider here is capital risk. Of course, with regards to your primary market, the government could default, effectively putting your capital at risk. But in the secondary market I could lose money without a default.
Having paid only R800 their yield is effectively 12.5% as they paid less for the same yield. That is ‘price down and yield up’
Let me explain. In this market I still buy a 10% yielding bond for R1,000. I get my R100 a year but after holding for a while I start to worry about a default and I want to sell my bond. However, the market is also worried about a possible default so while my bond has a face value of R1,000 I am only able to sell for R800. Yet, importantly, the buyer at R800 still receives the R100 a year interest, but having paid only R800 their yield is effectively 12.5% as they paid less for the same yield.
That is “price down and yield up”. The inverse is also true. Say, suddenly, everybody decided our government was the best ever and I could sell my bond for R1,100. In this scenario the buyer pays the extra, but still receives the set R100 interest a year. In other words, the buyer gets a lower yield of only 9.1%. This is “price up and yield down”.
The coupon is an old concept, not really used any more with electronic trading. But back in my grandfather’s day he would buy a coupon bond, in return for a certificate for the bond, to which the payment coupons were attached. Say it was the same R100 payment a year as in the example above. He’d tear off the relevant one for the year and take it to the issuer for his money. Very old school, and no longer really used.
Inflation-linked bonds increase the capital by inflation and then pay interest on that increased capital. Which is a nice and easy way to keep up with inflation and earn a set return.
Lastly, we have bond ETFs, which operate in the secondary market, so they run the risk of capital loss or gain with the yield up and price down or the inverse. These are the secondary market bonds most of us can access, given that the primary market for bonds (aside from the RSA Retail Savings Bonds) deals in huge sums. Most of us are unlikely to have tens or hundreds of millions at hand to buy bonds directly from the government.
Finally, as to whether you’d buy bonds now: the present higher yields could mean a capital gain if the yield decreases. But remember, that gain is itself offset by decreasing yields. Welcome to the bond market.
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