A: I'm not responding this myself, rather I'm quoting a reply from an experienced trader -:
Bonds are fixed income, and fixed capital as the interest payments are known in advance. This means that the interest rate cannot be increased in the face of rising inflation (as would happen with market interest rates), which subsequently means that bonds have their value (both income and capital) diminished by inflation. In addition, bond income is fixed, and if market interest rates rise, then the bond represents less good value that it did with low market interest rates.
Bonds therefore lose market value in the following circumstances:
The best time to invest in bonds is:
Bond prices fluctuate based upon a number of data points:
Bond prices as far as risk and volatility is concerned really boil down to a simple equation. If I loan you my money (by buying your bonds), will I get it back: all of it with interest, most of it, some of it, or in a damaging situation none of it. Investors traditionally place their cash investments in various allocations. High return, high risk, medium returns for taking on medium risk, and low returns, in volatile global market conditions, with low risk for supposedly safety and comfort.
Government Bonds - Gilts - your money is safe, you will get £1 back for each gilt on a specified date in the future and in the meantime you will get a coupon (interest/yield). Your money is deemed to be ultra-safe so the return is typically not fantastic. There are also index linked gilts and non-redeemable gilts...etc Interest on bonds (coupons) are paid annually on eurobonds and semi-annually on gilts and US treasuries.
Short Term Treasury bills - example 3 months, which bills pay no interest. They simply pay $100 on expiry. The price that investors bid for them determines the effective rate. E.g. if I pay $99 for a 3 month bill, I'm in effect getting a return of about 4% per year.
Corporate Bonds - your money is safe so long as the issuing company does not go bust. Assuming this doesn't happen you will get back £1 on a specified date, unless the bonds are perpetual bonds, in which case they go on just paying the coupon 'forever'. Like gilts they pay a coupon, unlike gilts the coupon tends to be paid once a year. Depending on the project that the company has embarked on the interest rate could be quite high (but so would be the risk) and may include an 'equity kicker' which would make the bond even more appealing to investors.
PIBS - not strictly bonds but they behave similarly. Issued by building societies, they pay back £1 on a specified date or are perpetual and are not due to be paid back at any time. Like gilts and Corp bonds they pay a coupon.
Convertibles are a type of bond which allow you to exchange the bond for shares at a pre-determined price referred to as a conversion price (set at a premium to the prevailing market price). This allows issuers to pay less interest than a conventional bond and also there are tax advantages involved.
Preference shares - not strictly bonds but pay a fixed divdend, known in advance but the dividend is only payable if there is money to pay a dividend. They are not redeemable, which means you have to sell them into the market to get your money back.
A rough guide to bond credit quality is provided by the rating agencies of whom the main ones are Standard & Poor's, Moody's and then Fitch. AAA is the very highest rating for any bond and this represents maximum safety. Standard & Poor’s and Fitch use the same system which in descending order runs: AAA, AA+, AA-, BBB+...etc while Moody's runs: Aaa, Aa1, Aa2, Aa3, Baa1... Bonds at or above BBB-/Baa3 are referred to as investment grade and any move down the ratings scale (downgrade) will lower prices. Lower ratings usually come with higher coupons to compensate holders for the extra risk.
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If you buy a gilt at £1, with a coupon of 5%, you are buying a yield of 5% and a yield to redemption of 5%. If you buy a gilt at £1.05 with a coupon of 5%, you are getting a yield of 5% but a yield to redemption of less than 5% because you will only get £1 when they are redeemed i.e. there's a small capital loss. If you buy a gilt at 96p with a coupon of 5%, you are buying a yield of 5% but a higher yield to redemption because you get a bit of capital gain. The actual yield to redemption can only be calculated once you know the redemption date. There is no need to hold a gilt to redemption and they can be sold for a profit/loss at any time. It is also possible to buy baskets of gilts...
Corporate bonds work in the same way. Buying Segro 5.75% 20/6/2035 @76p, buys you a yield to redemption of 7.74%. Buying bonds so far away is not something I would consider. More attractive to me would be Kingfisher Plc 5.625 15 Dec 2014 @ 79.325, giving a yield to redemption of 9.78%.
There is no need to hold a Corporate Bond to redemption, they can be sold at any time but liquidity can be an issue and the spreads can be quite wide.
...just to clarify, if you buy the Kingfisher 5.625%, you will get 5.625% income and £1 back on 15/12/14. If you need the money and the bond goes down in the interim you are, as they say, stuffed.
Yield to redemption can be calculated using excel.
It should be clear that we want to buy gilts/bonds at or below £1, otherwise known as par. Typically, gilt prices move up when interest rates are coming down and go down when interest rates are going up. Think again of our gilt at 5%...if interest rates on the high street are 6%, then nobody is going to buy a coupon of 5%, so the gilt goes down in price, which has the effect of increasing the yield to redemption. Gilt prices are also influenced by inflation and the overall health of the markets.
Corporate Bonds move more in line with the issuing company but there is still a relationship with interest rates and gilt yieds. Right now that relationship is in tatters and Corporate Bonds are offering some exciting yields for those willing to take on the risk i.e. that the issuing company won't go bust and that inflation won't go on the rampage. The Sunday papers are already picking up on this. There are a lot of funds out there so it's really not necessary to take on individual risk. There are also quite a few ishare basket funds.
Things to consider when looking into investing in bond issues are the sizes of issues as they define liquidity in a bond and for this reason bond issues below £500 million are best avoided as the secondary market will be illiquid. The volatility of a bond depends on a bond maturity date and coupon. The longer the bond and the lower the coupon rate the more volatile a bond will be.
No stamp duty is payable on Gilts or Corporate Bonds, there is also no tax on the coupon, it is paid gross. Ideal for an ISA but one can only put gilts/bonds with +5 years to run in an ISA.
I have mentioned on here that I've bought HBOA. This is a preference share, stamp duty is payable and coupon, or dividend as it is called here, is taxed at 10%.
I bought HBOA at 96p, it has a 9% coupon and is non-redeemable. Therefore, I bought a running yield of 9.3% and a yield of 9%. Since buying the price has gone up and the running yield is about 7.5%. That is still attractive compared with interst rates/gilt yields/dividend yield of most ordinary shares so, unlike Ben, I am not the least bit surprised it has continued to rise. I can sell for a capital gain, just like a normal share or I can just enjoy my 9% until HBOS goes bust ;-)
And that's it for now.
None of this is particuarly easy to grasp and I have over-simplified a bit. A good place to find out what's available is here, although their pricing is suspect. I have yet to find live prices and have always had to call my broker to place a trade. Bond coupons can be found here. Note that broadly speaking bonds can't be bought directly online - you have to call your broker and specifically ask for them.
One small point, you need to factor in inflation in terms of attempting to calculate an absolute loss or gain if held to redemption but this is true of any investment and is not particular to bonds.
One last point, and it's a bu@@er, is that when you buy a corporate bond, PIB or a gilt you have to pay for any accrued interest since the last coupon date. In return you get the full coupon on the payable date. In other words, if the last coupon was 30 days ago and the coupon was 5%, you will find yourself paying amount*5%/365*30 but you get that back at the next coupon date. This does not apply to preference shares.
Lastly, besides fixed bonds where the same coupon is paid each year there are other types of bond issues where coupon payments are tied to a benchmark such as Libor or the Consumer Price Index (CPI).
Bonds are often promoted as risk-free investments there is no such thing as a certain investment and even securities with guaranteed returns such as fixed interest government bonds can lose value when market interest rates (yield) exceed the original issue or discount rate. The other risks of investing in bonds include wide spreads, large minimum sizes and a lack of transparency as bonds are not traded on an exchange which means that it can be difficult to get pricing information.
...I am not qualified to give advice and you should not rely on anything I have written because it could all be unmitigated bowlocks.
A: There are a number of different rating agencies around the world. Moody's, along with Standard & Poor’s and Fitch Ratings are The Big Three. Moody’s competes with Standard & Poor's for the title of the world’s biggest credit rating agency. At present both companies control roughly 40% of the market share. Warren Buffett’s Berkshire Hathaway has the largest percentage share in Moody's with a 13 per cent stake.
Credit ratings are necessary for when companies and governments need to borrow money. This is achieved by issuing bonds. The bond pays a regular interest payment (the coupon) and then returns the initial sum borrowed at the end of the term (when the bond ‘matures’). Credit rating agencies assign credit ratings to issuers of bonds and other types of debt obligations as well as debt instruments themselves. These ratings reflect the sovereign's, company's or institution's credit worthiness and the risk that they will default on their debts. It is similar to, but more extensive than, a credit rating for your average consumer. If you have a good credit rating you will find you have access to the best deals on mortgages and credit cards and will be eligible for lower interest rates. Those with bad credit ratings will find it very hard to borrow money at all. Similarly companies and institutions with poor credit ratings find it harder to borrow money and are forced to pay higher interest rates.
Each rating agency has its own rating system. There is no definitive rating system which encompasses all companies and instruments. Instead rating agencies use a variety of esoteric rating systems for various different uses.. To help understand ratings, below is a table of The Big Three rating agencies' long-term corporate credit ratings.
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'[Moody's S&P and Fitch] have been in business a long time,' says Dr. Richard Sylla, professor of Economics at New York University. Much like Universities, older rating agencies are often considered to be better than their younger counterparts. This is not always the case. Credit rating agencies are a necessary part of the financial landscape as they give investors an insight into the credit-worthiness of a company. Companies (and countries) with a low credit rating will find it harder to borrow money. This may affect their ability to grow, which may affect profits, which may affect their ability to repay their debts.
Of course rating agencies aren't infallible. Lehmann brothers and AIG both had top notch ratings from both Moody's and Fitch before they crashed in 2008. This, coupled with many rating agencies 'rubber stamping' Collateralised Debt Obligations (CDOs) which some see as one of the causes of the financial meltdown of 2008, has tarnished the image of rating agencies across the globe. Dr Richard Sylla points out however that '[Credit rating agencies] use historical materials. When people came in and said, 'rate these CDOs,' which didn't have much history, some people said, ‘We can't really do that with our standard techniques.’ But each deal paid rating agencies $200,000 or $250,000 (£129,000 - £161,000), and so somebody there said, 'Find a way to rate them so we can make that money.'
We will probably always need rating agencies and for the most part their ratings do reflect higher and lower levels of risk. The important thing to remember is that these downgrades should not induce panic. Not only are they not a reflection of the financial stability of UK banks but there is always the possibility that the rating agency has got it wrong.
* with some excerpts from SVS CFD Securities report
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