Bonds explained Member of the London Stock Exchange
Killik & Co We pride ourselves on being a relationship firm. Each client has their own dedicated Broker, who acts as the single point of contact to provide award winning investment advice and trade execution, as well as handling any administrative matters. We provide our clients with wealth planning, investment management and advisory stockbroking services with access to all major asset classes equities, fixed income bonds, commodities and currencies - in over 30 markets worldwide. Independent research, from our team of analysts, who are frequently quoted in the press, is available to all our clients along with our Daily Note by email and our quarterly magazine Confidant. Killik & Co, your partner for investment and wealth advice. Contents 03 Introduction 04 Option One Investing directly in a bond 05 Option Two Investing in a bond fund 06 What is a bond? 06 Key features of a bond 07 Types of bonds 08 Gilts 09 Corporate bonds 10 Price and yield 11 Illustration 12 Accrued interest 13 Tax treatment 14 Why invest in bonds? 15 Factors influencing a bond s price 16 Managed Bonds Service 17 Calculations of cash flows Killik & Co Bonds explained 02
Introduction When the topic of investments comes up for discussion, it is frequently equities and movements in the global equity markets that dominate the conversation; bonds (sometimes referred to as fixed income securities) may not even be mentioned. However, bonds are an important asset class to consider when constructing an investment portfolio and may be particularly appealing to investors whose primary objective is the generation of income, or those with shorter time horizons and a lower willingness to accept volatility in their investment portfolio. Investors can choose to gain exposure to fixed income through direct investment in individual bonds or by investing in a fund. Both have their merits and the appropriate investment will depend on the investor s circumstances and attitude to risk. Killik & Co Bonds explained 03
Option One Investing directly in individual bonds Direct investment in individual fixed coupon bonds may be attractive for investors wishing to know with a high degree of certainty the timing and amount of income that they will receive from their investments. The income received will be a fixed percentage of the bonds principal value. For example, a 6% bond with a principal value of 100 will pay the holder of the bond 6 a year. This amount is known and does not change for the life of the bond, even if the price of the bond changes. Another advantage of investing directly in individual bonds is that you know the amount and the date of the principal repayment when the bond is held to maturity. Investors who have a liability that needs to be met at a known future date may benefit from a bond that matures, and repays the principal close to that date, whilst, in the meantime, receiving interest on the bond up to maturity. Killik & Killik Co Bonds & Co explained Life Stage young 04 professional explained 03
Option Two Investing in a bond fund For investors wishing to take a more diversified approach to investing, a bond fund can help to mitigate the issuer-specific risk that lies in direct bond investment. This approach may be particularly relevant for high-yield (or non-investment grade) bonds, which have historically experienced higher rates of default. However, investing in a bond fund offers less visibility than a direct investment in individual bonds, in terms of the underlying investment and the amount and timing of the interest payments. Additionally, whereas an investor in individual corporate bonds has the option of holding the bonds to maturity and receiving the principal repayment at that point, an investor in a bond fund is typically reliant on a market price to exit the bond fund investment. For the purposes of this booklet, we focus on investment in individual bonds. Over the next few pages, we examine the key features of a bond, look at different types of bonds available to the investor, and discuss a number of reasons to hold bonds in the portfolio. We also explore the inverse relationship between a bond s price and yield, and highlight a number of factors that can influence a bond s price. Killik & Co Bonds explained 05
What is a bond? In the same way that individuals may need to borrow money, for example to buy a house (i.e. a mortgage), governments, companies and other organisations need to borrow money for a variety of reasons. For the government, this may be to finance investment in infrastructure projects such as the building of roads or schools. And for a company, additional funds may be needed to enable the company to expand its operations. One way for these organisations to obtain funds they require to meet their objectives is to borrow from investors through the issuance of bonds. The bond that is issued is essentially an IOU indicating that the organisation has borrowed money from the investor. Key features of a bond The entity borrowing money is referred to as the issuer of the bond and the investor purchasing the bond (lending the money to the issuer) is referred to as the bondholder. The size of the loan represented by a bond is known as the principal, which is also referred to as its face value or par value. In most instances the principal represents the amount of money that the issuer will need to repay on a future date, known as the maturity date or redemption date. These maturity dates can vary and, depending on the length of time until maturity, bonds will typically be referred to as short-dated, medium-dated, or longdated. The interest that the issuer will pay to the bondholder is called the coupon, and is usually expressed as an annual percentage rate. In summary, investors purchasing the bond (the bondholders) are effectively making a loan to the issuer in exchange for a regular interest payment (coupon) and repayment of the amount borrowed (principal) on a future specified maturity date. The key features of a bond are usually evident from the way a bond s name is presented. For example: Tesco 5.5% 13/12/2019 This shows that the issuer, Tesco, has issued a bond maturing on 13 December 2019 and is paying interest of 5.5% a year on the bond. Killik & Killik Co Bonds & Co explained Life Stage young 06 professional explained 03
Types of bonds There are a number of different types of debt instruments available to the fixed income investor, the relative attractions of which may depend on the investor s attitude to risk. Credit rating agencies, such as Standard & Poor s, Moody s Investors Service and Fitch Ratings assign ratings to bonds to reflect the risk that the issuer will be unable to repay its debt obligations (default). Essentially, the ratings fall within two broad categories; investment grade and non-investment grade (also called sub-investment grade). For example, bonds with a Standard and Poor s rating of BBB- or above are considered investment grade and issues with ratings lower than BBB- are called sub-investment grade. An issue rated AAA is regarded as having the lowest default risk. INVESTMENT GRADE SUB-INVESTMENT GRADE Moody s S&P Fitch Aaa AAA AAA Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- Ca CC CC C C C D D Killik & Co Bonds explained 07
Gilts This is the name given to bonds issued by the UK Government and is short for gilt-edged. Gilts carry a credit rating of AAA from Standard & Poor s, Aa1 from Moody s and AA+ from Fitch credit rating agencies and are regarded as amongst the most secure sterling bonds in issue. In fact, they are often referred to as risk-free because the likelihood of the UK government defaulting on its debt obligations is considered to be extremely low. As such, the returns available on Gilts are likely to be more secure, but lower than the potential returns on riskier investments. Conventional Gilts Most of the Gilts in issue are conventional Gilts. These Gilts typically have a fixed coupon, will normally pay interest twice a year, and repay the principal at a specified future maturity date. For example, the holder of the 5% Treasury Gilt 2018 will receive two coupon payments of 2.50 per 100 nominal, in March and September, and repayment of the principal on 7 March 2018 (the redemption date). Index-linked Gilts Whilst most conventional Gilts pay a fixed coupon and amount at maturity, the twice-yearly coupon and the capital repayment on redemption for index-linked Gilts are adjusted to take inflation into account. The inflation measure used in making the adjustments is the Retail Prices Index (RPI). For index-linked Gilts issued prior to 2005 there is an eight month lag to the RPI level used and for issues from 2005 onwards a three month indexation methodology is used. See the example in the Appendix (page 16). Killik & Killik Co Bonds & Co explained Life Stage young 08 professional explained 03
Corporate bonds There are times when a company requires capital in excess of the cash that it generates internally. In such circumstances, the company could ask its shareholders for the funds (such as through a rights issue), or it may approach its bank (or banks) for a loan. Sometimes, however, the company s preference is for a third option; to raise the required capital from investors by issuing a debt instrument, such as a corporate bond. Unlike shareholders, who are partial owners of the company, corporate bondholders are creditors of the company. Thus the holders of the corporate bonds will not typically have voting rights or participate in future profits of the firm in the same way as a shareholder might, but the bondholder will typically have a higher claim upon the assets of the company in the case of bankruptcy. In addition, the cost of interest paid on the bond by the issuer is a chargeable expense to the business in computing its profit. There are occasions when a company may issue a convertible bond which gives the holder the option to convert the bond into the equity of the issuing company. Because the bond contains the option to convert, the issuers are usually able to pay a lower coupon on the bond, thereby reducing their fixed cost of borrowing. The advantage to the convertible bond holder is that he/she receives a combination of a bond yield and the potential to benefit from increases in the issuer s share price. If the issuer s share price does not perform well, and conversion does not take place, this would be a disadvantage, as the convertible will typically have a lower yield than a nonconvertible equivalent. Companies can also issue inflation-linked bonds in which both the coupon and the principal are linked to the RPI (Retail Prices Index) measure of inflation. These bonds usually follow an 8-month data lag methodology, which is the same as the one used for Gilts issued prior to 2005. Please note that the tax treatment of corporate inflation-linked bonds and inflationlinked gilts varies. For an example of inflation-linked gilts please refer to the Appendix. Killik & Co Bonds explained 09
Price and yield The price of a bond is generally quoted in relation to 100, or a percentage of its par value. Thus a bond trading at par will be priced at 100; a price of 80 means the bond is trading at 80% of the par value and a price of 110 represents 110% of the bond s par value. Although frequently issued at par (face value), corporate bonds are likely to trade at a premium or discount to this par value. Thus an investor who purchased a bond at par, and who decides not to hold the bond until maturity, will either make a capital gain (if the bond is trading at a premium to par) or loss (if the bond is trading at a discount) on the sale of the bond. As a bond moves towards maturity, its price moves towards par. These changes in the price of the bond affect the bond s yield. Killik & Killik Co Bonds & Co explained Life Stage young 10 professional explained 03
Illustration Let s assume an investor buys a corporate bond with a par value of 100, a coupon of 6% and that the bond matures in 10 years time. This investor will receive 6 of interest each year for 10 years. On maturity, in 10 years time, the investor will also get back the 100 principal of the bond; the loan to the issuer. The income yield (also called running yield or current yield) in the case of this bond is 6%, when the bond trades at par ( 6/ 100 x 100). Because the amount of interest is fixed, at 6 in the example, the bond s yield will fluctuate with changes in the price of the bond. If the bond s value were to fall to 80, then the income yield would rise to 7.5% ( 6/ 80 x 100). Conversely, if the bond were to rise to 120 the income yield would fall to 5% ( 6/ 120 x 100). Thus the bond s price and yield are inversely related. The yield that is most often used when comparing bonds is the gross redemption yield (GRY), also known as the yield-to-maturity (YTM). This measure is essentially the internal rate of return of the bond. It provides an indication of the total return the investor will receive from buying the bond at a particular price and holding it to maturity. It reflects the interest received, the reinvestment of that interest, and the effect of the capital gain or loss from holding the bond to maturity. The calculation of the yield-to-maturity is rather complicated and more easily computed with the aid of a financial calculator, but it can be approximated. The following paragraphs illustrate one of the simplest ways of approximating the gross redemption yield. Let s consider the above example, and assume the bond has ten years until it redeems at par ( 100). As demonstrated above, at a value of 80 the bond has an income yield of 7.5% (i.e. 6/ 80 x 100). To this we need to add the percentage growth in value to redemption, divided by the number of years to redemption, which in the case of this bond is 2.5% ( 20/ 80 = 25% / 10 = 2.5%). The result is an approximate GRY of 10%. Similarly, if the bond in the above example is valued at 120, it has an income yield of 5% ( 6/ 120 x 100). To this we would subtract the percentage loss in value to redemption, divided by the number of years to redemption, i.e. subtract 1.67% (- 20/ 120 = -16.7% / 10 = -1.67%). The result is an approximate GRY of 3.3%. Killik & Co Bonds explained 11
Accrued interest The price that is most often quoted for a bond is the clean price. This price excludes any interest which may have accrued on the bond. However, when you buy or sell a bond, the transaction will frequently fall between the date of the last coupon payment and the date the next coupon is due. This means that there will be a certain amount of accrued interest relating to the bond. When accrued interest is included in the price of the bond this is referred to as the bond s dirty price. This is the effective price that the purchaser will pay for a bond. Equally, the seller is entitled to receive proceeds that include interest accrued on the bond up to the time of sale. To illustrate, consider the Tesco 5.5% 13/12/2019 corporate bond with a clean price of 105.00 and 106 days worth of accrued interest. The amount of accrued interest for this bond is 1.60 (i.e. 106/365 x 5.5), which when added to the clean price makes a dirty price of 106.60. Thus, the cost to a purchaser seeking to buy 10,000 nominal of the above bond would be 10,660 ( 10,500 plus 160 of accrued interest). Killik & Killik Co Bonds & Co explained Life Stage young 12 professional explained 03
Tax treatment The coupon interest received on a Gilt, including the interestuplift on an index-linked Gilt, is taxable for a UK investor, but will normally be paid gross. Individual UK investors are not generally liable to capital gains tax or income tax on the disposal or redemption of a Gilt and no stamp duty is normally payable on the purchase or sale of the Gilt. Note that whilst the uplift in principal from the inflationlinking for index-linked Gilts is normally not taxable, corporate index-linked bonds may constitute deeply discounted securities for tax purposes. This means that profits made on transfers or other disposals (including redemptions) will likely be taxed as income. Corporate index-linked bonds may be best held within a tax wrapper such as an ISA or a SIPP. There is no liability to CGT following the disposal of a qualifying corporate bond and as with Gilts, there is ordinarily no stamp duty on acquisition or disposal. The majority of sterling corporate bonds will be qualifying unless they are convertible. Non-qualifying corporate bonds, however, are potentially liable to CGT following disposal. Generally, when a bond has accrued interest, the seller of the bond will be taxed on the income accrued up to the date of transfer. The purchaser of a bond will be taxed on the income accruing from the date of transfer. If the investor buys a bond which includes accrued interest, he/she will generally get tax relief on the interest accrued and will be able to deduct the accrued interest from the total interest amount received during the year when calculating the amount of tax due. If Gilts or corporate bonds are held in an ISA, the interest becomes tax free. Killik & Co Bonds explained 13
Why invest in bonds? There are a number of reasons why an investor may wish to include bonds in a portfolio, including the following: Reliable income Unlike dividends paid on equities which are normally discretionary and could be reduced or omitted if the company experiences a downturn in its fortunes, the interest income from bonds is usually known with a high degree of certainty. This makes bonds attractive to an investor, such as a retiree, who may require a reliable income stream from his/her investment portfolio. Visibility Direct investment in fixed coupon bonds offers visibility over the amount and timing of the coupon payments and also the repayment of principal at maturity, as these dates are known in advance. The interest also accrues daily, which means that an investor will receive income (accrued interest), even if the bond is sold before the coupon date. Diversification It is often appropriate that a portfolio contains a variety of asset classes in order to reduce the level of risk in the portfolio. For example, the inclusion of bonds, whether in the form of Gilts, index-linked Gilts, corporate bonds, or a combination of these, can play an important role in the diversification of a portfolio which may also include equities, due to the different characteristics of the respective asset classes. Lower risk Whilst the price of a bond can fluctuate from one day to the next, the interest payments and value at maturity of many bonds are known with certainty. Furthermore, Gilts (bonds issued by the UK government) are considered risk-free in terms of default. Whereas corporate bonds are riskier than Gilts in terms of default risk, in general an investment in high quality corporate bonds will be regarded as being lower risk than an investment in the company s equity. In the event of bankruptcy, bondholders will typically have a claim upon the assets of the company ahead of the shareholders. Tax-free capital gains Most sterling denominated bonds are qualifying and as such profits on disposal are not usually subject to capital gains tax. Also, there is ordinarily no stamp duty on the acquisition or disposal of a bond. ISA eligibility In most cases bonds will be eligible for inclusion within an ISA. Most bonds can also be held within a SIPP. Killik & Killik Co Life Bonds & Co Stage explained Life young Stage professional young 14 professional explained explained 03 03
Factors influencing a bond s price Please note that as with all investments there are risks involved in investing in corporate bonds. This includes the risk that the issuer may default. As a consequence you may get back less than you invest or lose your initial investment. Amongst the more important factors influencing a bond s price are changes in the level of interest rates (interest rate risk), the level of inflation, length of time until maturity, demand for the bonds, the issuer s financial position, a change in the issuer s credit rating and a change in the spread between the yield on corporate bond and the yield on a government bond with a similar maturity. Let s examine some of these factors more closely. Returning to our 6%, 10-year bond mentioned before, let s assume that interest rates increase, or are expected to increase. This means that companies seeking to raise money on the bond market would need to offer a higher coupon (e.g. 8%) on the new bonds they issue in order to attract investors. This would decrease the relative attractiveness of the 6% bonds already in issue, with the lower demand causing the price to fall until the yield on the bond is more comparable to the new bonds issued. On the other hand, if interest rates were to decline, companies could offer a lower rate of interest (coupon) on new bonds being issued, say 4%. This would increase demand from investors for the existing higher coupon (6%) bonds and force up their price. The higher price means that the yield on the existing bonds decreases. It is worth noting at this point that the outlook for inflation will impact bond prices since inflation erodes the value of money over time (purchasing power risk). Interest rates are usually raised in times of rising inflation and this is negative for bonds. The credit rating assigned to the issuer is regarded as an important determinant in the interest rate that the issuer will have to pay on the debt it issues (the cost of its debt capital). Investors will normally be willing to accept a lower rate of interest on issuers with the best credit ratings, regarded as having a lower chance of default, but for higher risk issues, investors will demand a higher interest rate. A downgrade in the credit rating therefore, can increase the yield commanded by the investor for the additional risk of investing in the bonds, leading to a lower price of the bond. Another factor that can impact the price of a corporate bond is a change in the credit spread. This is effectively the reward an investor demands in terms of extra yield for assuming the additional credit risk of the corporate bond over that of the risk free Gilt. The spread can be impacted by either issuer-specific factors, such as a change in the company s financial position, or factors affecting the broader bond market, such as a change in the economic landscape. In addition to the factors outlined above which can influence the price of a bond, it is important to note that marketability, or liquidity risk, is also a factor to consider when investing in bonds. This is particularly pertinent to corporate bonds where the secondary market for some issues may be quite thin and the spread between the buying (offer) and selling (bid) price may be quite wide. Certain bonds may also have issue specific risks which need to be considered. For example, some bonds are issued with a feature which allows the bond to be called before maturity, which can be disadvantageous to the bondholder. Note that, unlike a bank deposit, a corporate bond is not covered by the Financial Services Compensation Scheme (FSCS). Killik & Co Bonds explained 15
The Killik & Co Managed Fixed Income (Bonds) Service An investor can achieve broader diversification across sectors, maturities, levels of subordination and credit risks through a portfolio of corporate bonds. Killik & Co s Managed Fixed Income (Bonds) Service, run by our dedicated Fixed Income team, offers construction and management of bond portfolios. The team researches the Sterling bond market and is well positioned to take advantage of certain new issue opportunities and dislocations in the secondary market. The bonds are chosen via a thorough screening process, which includes an assessment of the fundamentals of the issuer and relative valuation of the bonds. Where investments are made in new issues, the Fixed Income team will normally meet the management of the issuing company as part of its assessment of the merits of the bonds. Secondary market trades in bonds are executed through a team of dealers, who seek out best market prices. Want more? If you want to know more about bonds or other fixed income investments, please call 020 7337 0777. Details of our fees and charges are available on our website. More info at: www.killik.com/bonds illik & Co Killik Life & Stage Co Life Bonds young Stage explained professional young professional 16 explained explained 03 03
Appendix Calculation of cash flows and estimated redemption price for an index-linked bond Let s consider the 2.5% Index-linked Treasury Stock maturing in July 2024. This index-linked Gilt was first issued on 30 December 1986. As this Gilt was first issued prior to 2005, the relevant lag to the RPI level used for the inflation adjustment is eight months. The base RPI figure for this issue is therefore the RPI eight months prior to the issue date, i.e. April 1986 which was 97.6679. This particular index-linked Gilt pays interest in January and July. Therefore, the relevant RPI levels applicable to these payments are those of the previous May and November respectively. The July 2014 interest payment per 100 nominal can therefore be calculated as: [Coupon/2] x [November 2013 RPI/April 1986 RPI] = [2.5/2] x [252.1/97.6679] = 3.2264 Thus for a holding of 100,000 nominal of this bond, the interest due in July 2014 is 3,226. In estimating the interest amount for January 2015 the applicable RPI figure to use would be the May 2014 RPI. In determining future interest payments in instances where the official RPI level for the relevant month is yet to be announced, it is necessary to make an assumption of future inflation to estimate the level. Once this level has been estimated the interest payment can be calculated. Based on the RPI figure for December 2013 of 253.4 and assuming a constant inflation rate of 3%, the estimated interest payment per 100 nominal in January 2015 for the bond in this example would be 3.2828. It is important to note, therefore, that unlike a typical conventional Gilt, the interest payment on an index-linked Gilt will fluctuate depending on the level of inflation. In estimating the price of an index-linked bond at redemption, it is necessary for the investor to make an estimate of what the RPI level will be eight months prior to the bond s repayment date. In the case of the above example, this is the RPI level for November 2023. In order to calculate this level, the investor must make an assumption about the RPI inflation rate from the time of the most recently released RPI figure to November 2023. For example, let s assume the most recent available RPI figure is for December 2013 which was 253.4. If we again assume an RPI inflation rate of 3% over the 119 month period from December 2013 to November 2023, then the estimated RPI level for November 2023 would be 339.7. This would mean that the estimated redemption price of the Gilt would be: [Estimated November 2023 RPI / Base RPI] x 100 = [339.7106 / 97.6679] x 100 = 347.82 per 100 nominal of the Gilt. Killik & Co Bonds explained 17
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