Bonds provide protection against stock market and real estate crashes Image Credit: Shutterstock

Dubai: When we talk about investing, we frequently talk about stocks. Stocks are likely to make up the bulk of your investment portfolio during the majority of your investing years.

Bonds, which tend to be less risky but also less rewarding, are more important as you get closer to retirement.

However, bonds can be a helpful part of your investment mix at any age, and it's important to understand how they work — even if you don't own many of them right now.

How to best design your investment portfolio for maximum gains
How to best design your investment portfolio for maximum gains Image Credit: iStock image

Let's examine bonds and why we should pay close attention to them these days.

How government bonds work

A bond is simply a vehicle that governments and companies use to borrow money. People buy bonds, and in exchange, receive interest payments. Our country would barely be able to function without bonds.

For the sake of this discussion, let's focus on government bonds. Globally, almost every government floats many different type of securities, but the most common are the 30-year and 10-year Treasury bonds.

These bonds pay interest every six months, and the principal amount of the bond — often referred to as the original amount or "par value" — is paid in full after 30 or 10 years.

There are also popular securities called inflation-protected securities. The principal amount of inflation-protected securities can go up or down depending on the movement of inflation, which is otherwise tracked by the consumer price index or CPI.

Government bonds are very popular worldwide because they are backed by the full faith and credit of the government, which has historically always repaid its debts.

Portfolio Balancing
How to best design your investment portfolio for maximum gains Image Credit: iStock image

Bond yield and price: What are they?

If you plan to hold onto a bond until it matures, you'll likely want to take a look at its yield, which is simply a calculation of how much money you'll make on the investment.

So for example, let's say you have a $10,000 (Dh36,700) 30-year bond with an annual interest rate of 5 per cent. This would mean you'd get $500 (Dh1,835) per year. This is the bond's annual yield. It's also referred to as the "nominal" yield.

There's another factor that determines how much money you make from a bond, and that is price.

Let's say that the owner of the $10,000 (Dh36,700) bond above chooses to sell the bond before it matures, for $9,000 (Dh3,305) — maybe because the issuing company is struggling to stay afloat, or because interest rates are about to see a substantial rise.

The buyer of the bond will still continue to get interest payments based on the face value of the bond ($10,000 or Dh36,700). These interest payments are fixed.

Thus, the buyer is receiving the same payments, but because the buyer paid less for the bond, the yield is 5.55 per cent. ($500/$9,000 or Dh1,835/Dh3,305)=0.0555, or 5.55 per cent).

When a bond is selling for more than its issue value, we often hear people say it is trading "at a premium. “If it is selling at less than its issue value, it is selling “at a discount”.

Generally speaking, people seek to find bonds selling at a discount, because they result in a higher yield.

What does it mean when a bond trades at a premium or discount?
A discount is the opposite of a premium. When a bond is sold for more than the par value, it sells at a premium. Conversely to a discount, a premium occurs when the bond has a higher interest rate than the market interest rate (or a better company history).
Picture used for illustrative purposes.

Why do bond prices rise and fall?

The price of bonds is very closely impacted by a country’s interest rates. The prevailing interest rate — that is, the interest rate on bonds being issued at that particular time — can make any other bond seem more or less attractive to investors.

To illustrate this, let's say you hold a 30-year bond with a 5 per cent interest rate, but rates have been rising and now average 6 per cent. Because your bond now has an interest rate that is lower than the prevailing average, it's less attractive to investors.

Thus, if you want to sell the bond, you may have to lower the price to ensure investors can get the same yield.

The opposite is also true. When interest rates are falling, any bond with a higher interest rate becomes more attractive and can demand a higher price.

Inflation is known to indirectly impact bond prices because it is accompanied by higher interest rates.

Bond prices are also indirectly impacted by the performance of the stock market. When the stock market is doing well, people tend to flock to stocks and their potential for higher returns, which in turn depresses demand and prices for bonds.

But during times of economic distress, like the pandemic-induced downturn that was recorded recently, investors will often flock to the relative safety of bonds and this can cause prices to rise.

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Why do bonds matter now matters now

The bond market has become surprisingly quiet in the past few months, but the prospects remain bright.

“As global economic growth strengthens this year, bonds investors may find opportunities in high quality bonds, higher-yielding debt and assets that hedge against a declining US dollar,” evaluated analysts at US lending and investment major Morgan Stanley.

Government bond yields have still been edging higher in 2021. For instance, the interest rate on a 30-year Treasury bond grew to about 2 per cent as of the end of August. The yield on the 10-year Treasury is more than 1.5 percent.

There are many reasons why yields have increased over the years, but generally they have to do with confidence in the economy and in the stock market. Treasury yields rise inversely to prices. Thus, a high yield suggests that demand for bonds is weak and that's depressing prices.

The trend is only expected to strengthen. The governments globally is predicted to issue a lot of new bonds in 2021 as it looks to cover the cost of new tax cuts. Having more bonds in the market will lower demand for any individual bond, so prices will fall and yields will rise.

190312 uae central bank
The UAE Central Bank located on the Baynoonah street in Abu Dhabi. Image Credit: Gulf News archives

2021: A year of recovery for bonds

“As fixed income investors, we expect 2021 to be a year of recovery,” the Morgan Stanley analysts forecasted earlier this year.

Many economic forecasts show GDP (gross domestic product, key gauge of economic growth) increasing, and it begs the question: Won’t bond market yields rise in this environment? Rising yields of course mean falling bond prices—at least on paper for investors who own the debt.

However, yields will be rising for good reasons, based on economic growth and cash flow returning to markets.

“Bond market movements will act as key indicators of the health of the recovery, as well as corporate performance and consumer confidence in 2021 and beyond,” the analysts added.

“As economic growth strengthens (most likely in inverse proportion to the severity of the pandemic this year) and variation in the fixed-income market broadens, so will the opportunities for bond allocators.”