A share represents part ownership of a company's equity and the right to a slice of its future dividend income. A bond is an IOU, a slice of debt. Think of it as an interest-only mortgage, except with you playing the role of bank. You're lending a company money. In return, it pays you interest - and pays back the capital at the end of the loan term.
If a mortgagee loses his job and can't pay the mortgage interest, then the bank may repossess his house, and to an extent, that happens in bonds too. If a company becomes insolvent, bondholders are higher in the pecking order than equity shareholders and are more likely to get at least some of their money back.
Par, coupons and yield
As with most loans, the terms are fixed at the start. The price bonds are issued at is termed 'par' - and unless the bonds are convertible into equity, that's the price they're generally redeemed at, too. The amount of interest to be paid, known as the coupon, is expressed as a percentage of the par value and is also constant throughout the term of the bond.
But the price can vary. So the running or current yield - the coupon expressed as a percentage of the price right now - rises when the price falls, and falls when the price rises. Understanding this inverse relationship is key to understanding the bond market. The formula for calculating yield is:
Current yield = (Par value ÷ price) x coupon
Redemption yield (RY) is slightly more complex, as it factors in the price and yield now, time to maturity, and redemption price. The formula is:
RY = CY + [(par - price) ÷ years to maturity]
EXAMPLE OF YIELD CALCULATION... A bond is issued at £100 par value and pays a coupon of 5%. The term is 10 years. Two years from maturity, it's trading at £89. The running yield is 5.62% (100 divided by 89, then multiplied by 5%). The redemption yield is 5.62% plus 5.5% = 11.12%. The extra 5.5% comes from the difference between par and the current price (11), divided by years to maturity (2).
One effect of the redemption yield calculation is that small differences in price have proportionately more impact on redemption yield the closer a bond is to maturity. In the example above, if the price had been £89 with five years to go to maturity, the yield to redemption would have been 7.82%.
For more on how to calculate running and redemption yields, along with examples, see our investment guide to bonds.
The role of rating agencies
The vocabulary of the equity analyst is easy to understand. Terms like "buy", "sell", "overweight", "accumulate" and so on, are pretty self-explanatory. Such recommendations are often arrived at by computing an estimated value for the income that a share is likely to generate in the future, and comparing that value to the current share price.
The lexicon of the bond analyst, by contrast, seems impenetrable. "Ratings for Acme Corporation downgraded to AA- and placed on creditwatch with negative implications". That's because the bond analyst is not in the slightest bit interested in a company's growth profile or whether its shares will outperform an index. S/he cares only whether the company is financially strong enough to honour its interest payments as they fall due, and whether it can redeem its bonds at maturity. Bonds are said to be "investment grade" if rated above a certain level. Below that level are "sub-investment-grade", or "junk" bonds. These often carry attractive yields, but the risk of default is proportionately greater.
And whereas there are dozens of stock brokers and investment banks, bond ratings are dominated by three companies: Standard & Poor's, Moody's and Fitch. Bond issuers pay these entities to rate their bonds, because a bond with a rating is easier to sell to investors. Of course, there's a potential conflict of interest there, one that's come into sharp focus following the sub-prime crisis in the US, when a lot of supposedly investment-grade debt blew up in investors' faces.
Table of equivalent ratings
| Moody's | S&P/Fitch |
|---|---|
| Investment grade bonds | |
| Aaa | AAA |
| Aa1 | AA+ |
| Aa2 | AA |
| Aa3 | AA- |
| A1 | A+ |
| A2 | A |
| A3 | A- |
| Baa1 | BBB+ |
| Baa2 | BBB |
| Baa3 | BBB- |
| Sub-investment grade ("junk" or "high-yield" bonds) | |
| Ba1 | BB+ |
| Ba2 | B |
| Ba3 | B- |
| B1 | CCC+ |
| B2 | CCC |
| B3 | CCC- |
What moves bond prices
For junk bonds, the main price mover is the perceived risk of default. The main influence on investment-grade bond prices is investor expectations of future interest rates, because interest on bonds is fixed. Take, for instance, a bond paying a coupon of 4.5 per cent of par. If interest rates are expected to rise, the attractions of interest fixed at 4.5 per cent diminish, and so the bond is likely to come under selling pressure (thus raising the yield). Conversely, if rates are expected to fall, then a 4.5 per cent coupon could start to look attractive, and the bond would be in demand. Prices would rise, and yields fall.
Because there is less visibility about long-term interest-rate expectations, and less certainty about corporate solvency, longer-dated bond prices tend to be more volatile than short-dated ones.
Risk aversion is another factor. Investment-grade bonds offer a relatively high degree of certainty, so they are sought-after when investors want out of riskier assets. The chart below illustrates this. It shows the yield gap between an index of US high-yield bonds and US Treasuries, compared to the Chicago Board of Exchange's Volatility Index, (Vix, the so-called fear gauge).
Finally, there's good old supply and demand. Private investors' love-in with fixed-income may be a relatively recent development, but company pension schemes have been shifting out of equities and into bonds for years. And relatively undeveloped bond markets in Asia have led to large amounts of Asian savings flowing into US and European fixed-income.
