Bonds operate like an IOU, whereby you lend your money to the issuer for a set period of time, in return for interest paid over the term of your investment. Your investment, or capital, is then paid back to you in full at the end of the investment term.
Fixed interest securities can be traded on the secondary market before their maturity. This is usually how bond funds are managed. Fund managers trade securities with the aim of profiting from price fluctuations.
Bond returns the 101 of fixed interest securities
The main types of fixed interest securities are:
The table illustrates the capital stack ranging from the most secure at the top down to the least security represented by equity.
Semi-government bonds – not issued directly by a government but might have a direct or implied guarantee. For instance, state governments and other entities that have a government guarantee (like the World Bank) issue bonds to support their financial needs or to finance public projects.
Government bonds – issued directly by a government. For instance, in Australia the federal government issues commonwealth securities to help pay for major government projects.
Corporate debt – Governments don’t issue equity but typically corporate issuer’s draws the distinction between debt and equity securities as well as hybrid securities which contain features of both. Knowing where a security sits in the capital stack is a key requirement when investing in fixed interest. Types of corporate debt securities are:
Senior Secured Debt – If a company is declared bankrupt or enters liquidation, senior secured debt holders have first claim over specific assets of the Issuer. This is because this class of investor or lender has direct and definable security or legal charge over specific assets of the company e.g. mortgage/lien over real property or other assets.
Senior Unsecured Debt – As we move down the capital structure the probability of receiving all of the money invested decreases in the event of a company’s failure. The expected level of recovery will vary depending on the initial financial strength of the company with senior unsecured creditors having first access to the proceeds in the event of liquidation (behind any secured lenders). Most corporate debt is issued on an unsecured basis.
Subordinated Debt – This is another notch down in the capital structure and while still debt with a defined maturity date and interest payment obligations, in the event of wind up, the interests of the subordinated-debt holders will rank behind the senior debt holders (both secured and unsecured). Companies often issue subordinated debt as, depending on the terms of the security, it will support the corporate credit rating assigned by ratings agencies. This effectively provides them with what is referred to as “equity credit” (discussed in more detail further on in this document).
Capital Notes and Preference Shares – Capital Notes and Preference Shares, often referred to as Hybrids, pay dividends which rank ahead of the payment to ordinary shareholders. These securities follow the sequential nature of risk, just as subordinated debt is subordinate to other forms of debt; hybrids are subordinate to all forms of debt, but generally rank ahead of ordinary equity in the event of a wind-up.
Ordinary Equity – Finally, ordinary equity sits at the bottom of the capital structure. If the financial position of the company deteriorates, equity investors rank behind all other investors. This arises from the fact that there is no obligation to repay equity or provide any income stream; companies are not breaching security terms or breaking any laws by losing shareholder value or not paying dividends.
There are risks associated with moving down the capital structure from senior secured debt to ordinary equity which include:
- A reduction in the security of cash flows;
- No recourse against an issuer should payments not be made or capital is put at risk;
- Liquidity in the instrument may decrease particularly in times of financial stress; and
- Ranking or priority of claim in the event of the issuer being wound up.
Key terms used in debt markets
There are a number of terms used in the fixed interest markets which are key to understanding the market:
Cash running yield: Is calculated as the cash distribution payable to holders based on the security’s issue margin plus the one year swap rate divided by the last traded price of the security. This calculation provides an indication of the expected return over the next 12 months.
Yield to Maturity/Call: The expected return having paid the published current price and assuming all distribution payments are made through to maturity. The calculation assumes investors realise the face value of the security and fully utilise any franking benefits.
Trading margin: The Yield to Maturity minus the relevant swap rate and shows the return premium required by investors to purchase the security rather than investing in bank bills. For example, if a security has a YTM/YTC of 7.00% and four years to maturity, this would be benchmarked to the four-year swap rate (e.g. 4.00%); subtracting this from the YTM/YTC gives a trading margin of 3.00%.
Swap rate: This is a benchmark yield that is determined on a daily basis by a panel of banks across a range of terms and provides a benchmark from which a range of financial instruments and transactions are priced.
Risk and return characteristics
In general fixed interest is a low- to medium- risk investment suitable for investors with a timeframe of three years or more.
In addition to providing a regular income stream – an important feature for many investors – fixed interest may provide a stabilising effect during periods of share market volatility.
Total bond returns can include income from interest payments and growth from price fluctuations. Bond yields are inversely related to bond prices. When bond yields rise, bond prices will fall and vice versa.
Bond yields and prices may fluctuate regularly based on the economic outlook. Bonds can provide capital growth (and loss) when sold prior to the maturity date for a higher (or lower) price.
Credit risk refers to the risk of an issuer defaulting on repayment of capital. Credit ratings provide a good indication of the risk level associated with the issuer. Bond issues are rated by independent rating agencies like Standard & Poor’s. The higher the rating the less likelihood of the issuer defaulting on repaying your capital. Usually, the higher the risk, the higher the yield.
Theoretically returns are generally commensurate with an investments position within the capital stack. The level of risk vs reward is something the Shartru Investment Management spends considerable time contemplating.
Risk and return of various securities in the capital stack