Investing in a bond ETF like the NewFunds Govi ETF is an easy way to balance out a portfolio by adding some low-risk debt. This week, Just One Lap user Neil Wolhuter tries to make sense of the relationship between bond prices, interest rates and yields. He sent the following question to email@example.com:
Please confirm for me: If interest rates go up, bond prices go down, and therefore bond yields go up?
If SA gets a downgrade and I am holding bond ETFs, will I be better off or worse off?
We’ve wrestled with bonds on The Fat Wallet Show. The relationship between interest, bond prices and yields might seem confusing at first. Here’s what you need to know:
It helps to think of bonds as an IOU from the government. When you buy a fixed interest rate bond or bond ETF, you are lending money to the government in return for a fixed interest rate (also called a coupon) over time. Each bond has a maturity date – the day you will get your money back. Bonds with a longer date to maturity tend to pay more interest than shorter-term bonds, because there’s more risk of something going wrong over a longer period. By the maturity date, you will have the original amount you invested (also called the face value of the bond) as well as the agreed-upon interest paid over that period.
Prices down, yield up
You can sell your bond before it reaches maturity. When you sell a bond, you can either sell it for more or less than the face value. If, for example, you worry that the government won’t pay you back by the time your bond reaches maturity, you would be willing to sell it for slightly less just to be rid of it. When you sell the bond at a lower price, the interest the person buying the bond will receive will be higher as a percentage of the value of the bond.
For example, if the bond you have has a face value of R1 000 and a coupon of 10%, you will receive R100 per year in coupons, as well as R1 000 at maturity. If you sell the bond for R900, the person who buys the bond will still receive 10% on the face value of the bond and the R1 000 at maturity. The yield is therefore higher when the bond price goes down.
If, on the other hand, there is suddenly a huge demand in the market for your bond and you can think of something better to do with your money, you can sell the bond for more than face value. Your R1 000 bond sold for R1 100 will still only pay out a 10% coupon on the face value of R1 000. By the time the bond reaches maturity, the person who bought the bond from you at a higher rate will only receive R1 000 back. The yield is lower when the bond price goes up.
Interest rates up, bond price down
An interest rate hike will negatively affect the price of your bond, because new bonds are issued at the higher interest rate. When an investor buys a bond, they would want a bond with a higher interest rate. If you sell your bond at the lower interest rate, you would have to sell it below face value to compensate for the old interest rate.
What if we are downgraded?
A government’s credit rating is a big deal, because it indicates how likely it is to repay its debts. When a government’s credit rating gets revised down, it means the world at large thinks there’s a chance the government might not meet its debt obligations. Investors are far less likely to lend money to a government who might never pay them back. A government with a low credit rating is therefore a risky investment.
To compensate investors for taking a higher risk, the government has to offer a higher reward. In the case of bonds, this means paying more interest. A downgrade to South Africa’s credit rating will affect the bond market in two ways:
- Holders of existing bonds will likely want to get rid of them. A higher supply of bonds in the bond market will drive the bond prices down, creating an opportunity for investors with a higher risk appetite to buy bonds at below face value. As we illustrated above, this will mean higher yields on existing bonds.
- The government will have to pay higher interest on new bonds to compensate investors for taking on more risk, also resulting in higher yields.
If you already hold a bond or a bond ETF when we are downgraded, your investment won’t be affected unless the government defaults on its debt obligations. You will continue to receive the coupon and get back the face value of your bond when it reaches maturity. However, should you decide to sell the bond before it reaches maturity, you would most likely have to sell your bond at below its face value, leaving you worse off.
Click here to meet the Just One Lap team at one of our live, free events.