In the intricate world of investment, the role of bonds as a tool for wealth preservation cannot be understated.
According to Capgemini’s 2023 world series report, 67% of high-net-worth individuals prioritized wealth preservation as a critical objective, a mindset that often leads to a more conservative portfolio with a significant allocation to bonds.
This article explores the intricacies of bond prices, diving deep into the factors that influence them between their issuance and maturity; this includes credit risk, duration risk, and reinvestment risk, demystifying their relationship with bond pricing.
As mentioned in our foundational piece, if a bond is held to maturity, you know exactly how much you are getting, when you are getting it, and more or less have certainty on your cash flows (except in the case of bankruptcy).
With that said, one of the benefits of bonds is that they are securities, meaning that the contract between the lendee and the individual holding the bond can be sold to any other investor/lendee. This ensures there is liquidity in the event the lender would like to exit the arrangement earlier than anticipated; in this case, the lender would have to sell at the value of the best buyer at the time (which could be either higher or lower than the maturity value).
The reason this is a massive benefit is that it allows lenders to exit early should they have an event that requires liquidity.
To use an example, Ryan is a very conservative allocator who aims to secure his cash flows and decides to invest in multiple bonds each maturing in an average of 10 years. He has relative certainty that he will not be needing the money till at least retirement in 20 years, where he will likely continue to be invested to yield income instead of drawing down on his savings/capital.A few years down the road, after a long and specialized career, he decides to open his own business which requires more of his savings than he has in cash. Ryan therefore looks to his bond portfolio to get some money out and decides to liquidate 20% of it to allow him to invest in this new venture. Although there is utmost certainty on cash flows till maturity, to partially liquidate his portfolio, he will need to sell the bonds based on their current market value (the prices that other investors are willing to pay up for those securities). Considering the total size of the bond market, there is a plethora of liquidity based on people/institutions continuously buying/selling bonds in the market space.
The above example highlights the importance of investors' understanding of why bond prices rise and fall. However before we dig into these details, we need to double down that these price changes have no effect whatsoever if bonds are held to maturity and in the absence of a credit event (bankruptcy or lendee unable to repay). Let’s dive deep into what would drive bond prices between issuance and maturity:
The easiest price sensitivity to understand is definitely credit risk. To reference our previous example of Fujairah Airways (“FA”) (link to that article/example), if an investor owns an FA bond, one of the most impactful risks is FA’s ability to repay its loans. Let’s assume its’ 2020 again where a global pandemic came about, travel came to a halt, and the pressure on airline’s profitability was immense, strongly hindering their ability to repay interest and debt. The increased risk and decreased desirability in such a case would understandably have an impact on the bond's price: since the bond's annual returns are fixed in the contract, the seller would have to lower the price of the bond itself. With a lower purchase price and the same annual return, the new buyer is yielding a higher return than the original investor was for taking on a higher risk.
However the opposite also holds true: in the event where the credibility of the lendee has increased significantly, there would be a very high demand for such a bond, driving its value upwards as investors would accept a lower yield for the security of a higher quality lend.
To summarize, the main risk when investing in bonds is the lendee’s ability to pay the interest due and pay back the principal. This is credit risk: the higher this risk, the higher investors would demand in return to lend; the lesser the risk, the more desirable the opportunity.
Interest Rate Risk, more commonly known as Duration Risk
Interest rate risk is the risk of interest rates moving upwards whilst you are holding a bond. This is an essential risk for investors should they need to sell their bonds before maturity, and it's related to the opportunity cost for other investors.
To understand this fully, let's use an example: it's January 2022 and interest rates in the market are near 0 on deposits. Nadia, another conservative investor, decides to buy a 10 year high quality bank bond, issued by City-Banque (“CB”) that is returning an annual 3%. For Nadia, this was a logical decision, as she was unwilling to own any other assets, and instead would rather lend money on a guaranteed basis knowing exactly how much return she is getting back and when, rather than her funds sitting idle yielding 0% in a bank account. In 2022 and to mid-2023, short-term market interest rates on the USD increased significantly from 0% to 5%+, creating the ability for individuals to yield healthy short term returns on their savings. This of course would have a high impact on Nadia’s ability to sell this bond. Now let's remember, if Nadia holds this to maturity over 10 years, she will get exactly what she had signed up for: 3% per annum and her money back guaranteed by City-Banque. Now let’s assume that Nadia’s dream house has just been put up for sale at a very discounted price, and she needs the liquidity to buy. She would not be able to sell this bond at its original price as there wouldn't be anyone interested in a return of only 3%. Nadia originally bought this bond for $100, was receiving $3 a year, and would be getting back $100 upon maturity. To sell this, she would now need to lower the price to $80 to find a suitor willing to take this from her to benefit from the higher yield and the price appreciation from $80 back to its eventual maturity value of $100.
Essentially the above example portrays interest rate risk: a rise in interest rates will lower bond prices that are available for sale and not being held to maturity; this risk is commonly known as Duration risk as well since the longer the maturity/duration period is, the higher the risk. If Nadia's bond was maturing in 1 year, the price would definitely not have declined as much considering its close maturity, a simple decline of price of $5 would have attracted enough buyers to pick up her bond that would yield more than 8%. At the same time, if the bond was maturing in 30 years, the bond price would have declined even further considering the very long tie up.
The opposite holds true, if Nadia was holding a 5-year bond yielding 6% in 2023, and interest rates go down, her bond would become much more attractive to buyers than the original price should she look to need the funds and/or sell.
Now interest rate risk has a cousin that is not spoken about enough, reinvestment risk. Reinvestment risk is the risk for those investors who actually own bonds until their maturity having certainty on the incoming cash flow. For these investors, once the bonds mature, they receive back cash for which they now need to allocate towards other income-yielding investments at a time where they do not know what to expect.
Using Nadia’s last example, she is holding a 5-year bond yielding 6% from 2023 to 2028. She chooses to not care about anything going on in the market or with interest rates as she has the comfort of knowing exactly what to expect, a 6% return on an annual basis. It's 2028 now, and Nadia receives back her original investment of $100. She goes to her financial advisor and asks to place another bond or deposit as she would like to continue generating income from her funds to support her lifestyle. To her surprise, her advisor explains to her that interest rates are back at 0% and longer-date high quality bonds are not yielding more than 3%. This is upsetting news to Nadia as this would require her to generate 50% less income than she had gotten used to and significantly impacts her lifestyle.
This risk is maybe the most under-appreciated whilst we write this in June 2023. The amount of investing that has gone to shorter term deposits, cash, and money market funds returning circa 5% has made many investors happy with short-term gains, however over-exposed to a situation where interest rates could go back down over longer periods of time. Investing in bonds allows investors to lock up their return for longer, appreciating more certainty on their returns and also benefiting from interest rate declines. With interest-rates at levels not seen for decades now, bonds look like a very interesting place to be and key to investor’s portfolios.