Bond Basics for Beginner Investors29/6/2023 The Financial Times (FT) recently reported that for the first time, the S&P 500, corporate investment-grade bonds and treasury bills are all offering the same yield of 5.3% for prospective investors. The leading financial newspaper provided a useful graphic depicting the three respective yields over the past decade. 
Price-to-Earnings or Earnings Yield?By including the S&P 500 in this group, the FT is referring to what is called the “earnings yield,” which is the inverse of the well-known price-to-earnings (P/E) ratio. For example, a company that has a market capitalisation of $200 million and earns a profit of $10 million would have a P/E ratio of 20x (P/E ratios are often quoted as last twelve months “LTM”, trailing twelve months “TTM”, or next twelve months “NTM”, each of which refer to when the $10 million in profit was or will be earned). A P/E of 20x equates to an earnings yield of 5% (i.e., 1/20 x 100 = 5%).
Alphabet SoupCorporate bonds receive credit ratings that assess their risk of default (not paying investors interest or principal) from agencies including Standard & Poor’s (S&P), Moody’s and Fitch. These ratings range between AAA (meaning an extremely strong capacity to meet financial commitments) and D (in default) by S&P and Fitch, and from Aaa through C for Moody’s. The higher parts of these ranges are known as “investment grade” (BBB/Baa3 and above) and the lower parts of the ranges (below BBB/Baa3) are referred to as “non-investment grade” or “speculative grade”, or more commonly, “high yield bonds” or even “junk bonds.” This is quite an important distinction because investment grade companies are far less likely to default during times of economic stress and their cost of debt is much lower than speculative grade companies.
Risk-Free (Mostly)Treasury bills (T-Bills) are short-term government bonds typically ranging in duration from one month up to one year. T-Bills do not pay the investor a coupon. Instead, “interest” is the difference between what the investor pays and what they receive when the bill matures. For example, based on the 5.3% quoted by the FT above, an investor that purchases a one year T-Bill for $95 would receive $100 at the end of the 12-month period. T-bills is more of the convention for the U.S., whereas short term government bonds are usually called Treasury Notes in Australia
Are All Yields Created Equal?The FT article categorised the three different potential investments as medium risk (S&P 500), low risk (corporate bonds) and no risk/risk-free (treasury bills). It also stated that “investors lose the incentive to own US equities,” implying that with each of the investments yielding 5.3%, investors should prefer T-bills and corporate bonds over the S&P 500.
All else being equal, it’s true that investors should prefer government bonds over corporate bonds. Companies risk defaulting on their debt obligations, giving investors what is referred to as credit risk. A government that issues debt in its own currency, such as the United States or Australia, on the other hand, is likely to be able to raise taxes if they need additional funds to meet their financial commitments. This is why corporate bonds usually pay a higher interest rate than government bonds [Johnson & Johnson, NYSE: JNJ, and Microsoft, NASDAQ: MSFT, are rare companies that also carry the highest AAA credit rating]. This difference is known as the “credit spread.”There are times though when investors might prefer corporate bonds over T-bills. For example, if an investor thinks that the economy is going into a deep recession and interest rates are likely to fall, they may prefer a longer-duration corporate bond (perhaps 5 years or 10 years) with a similar coupon rate to the short-term government bond. This is because the investor will continue to receive the stated interest rate for the full 5 or 10 years on the corporate bond, while with a T-bill, they will have to find a new investment within 12 months that might pay a lower interest rate (the central bank can lower interest rates as quickly as they raise them, as we saw during the early days of the pandemic).
The S&P 500 might also still be the best option for some investors. Inflation can be a real dampener on the profit margins of some companies–particularly those with a lot of labour and material costs. Other businesses, though, have extremely good inflation protection. These include infrastructure companies (that have already built their assets and are able to lift prices, such as an airport, toll road or pipeline), brokerage services (insurance or mortgage brokers for example, that take a commission based on the nominal cost of a product or service), and certain other financial institutions (in many cases banks, who again deal in nominal prices). There are also businesses that provide such a great product or service to their customers that they are able to raise their prices without reducing demand, an attribute known as “pricing power.” Bonds, on the other hand, can be severely impacted by high inflation and rising interest rates.
What Happens to Bonds When Interest Rates Rise?The Australian Financial Review (AFR) recently published an article entitled “Australian investors have no idea how bonds work.” It suggested that while more than a quarter of Australian investors are confident that bonds will outperform equities in 2023, around 64% did not understand what happens to bonds when interest rates rise. This data was based on a survey of 8,550 individual investors with more than US$100,000 in assets conducted in March by Natixis Investment Managers, a US$1.2 trillion (AU$1.8 trillion) global asset manager.
The results of the survey were dismal around the globe, with only 1.7% of international investors selecting the correct answers–that when interest rates rise, the current price of a bond decreases and future income increases. While Taiwan (5%) and Hong Kong (4%) had the highest rates passing the quiz, Australia performed extremely poorly at only 0.5%. The 64% of Australians who responded “I don’t know” was nearly double the second-worst result, which came from the Netherlands.Only 18% of Australian respondents said they had invested in bonds–a figure that might be an overestimation. The survey included only 400 Australians and the recent ASX 2023 Investor Study showed a much lower result, with only 6% of Australian investors having bonds in their portfolio!
Boost Your Bond KnowledgeThe rapid rise in interest rates over the past 12-18 months has made bonds a far more interesting investment than at any time since the Global Financial Crisis. Bonds are a very useful asset class that can provide investors with stability, income and much-wanted diversification. They come in all shapes and sizes: durations between 1 month and 30 years, they are issued by corporations and governments, they pay coupons based on fixed and floating interest rates, some of which are linked to different inflation rates, and in a variety of currencies. There are certainly reasons to continue investing in growth assets including shares and properties, but now could be a great time to boost your knowledge and take advantage of the emerging opportunities in the enormous global bond market.
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Bond Basics for Beginner Investors
Bond Basics for Beginner Investors
