Trust Management Educational Series
Most investment portfolios of charities have an allocation to bonds. Bonds are less risky than shares, but may still generate negative returns from time to time.
A typical bond fund includes bonds issued by companies, councils, and governments.
What is a bond?
A bond can be thought of as a type of loan, with the issuer of the bond agreeing to repay the borrowed amount on a promised maturity date, as well as make interest payments in the meantime.
Elements of a Bond
Face Value The face value is the amount of the “loan” that will be paid out on maturity
Coupon The coupon is the interest payment - typically coupons are paid six monthly
Maturity Date The date the face value will be paid out
Term The length of time until the maturity date
Premium/Discount The difference between the face value of the bond and the price
Credit risk is the risk that the bond issuer doesn’t pay the promised interest payments, or doesn’t repay the face value of the bond on the maturity date. This can happen if the bond issuer has financial difficulty or becomes insolvent. Some bonds have more credit risk than others; bonds issued by a company are generally riskier than those issued by the Government.
Bonds can be bought when first issued or subsequently in the open market. As interest rates change, other purchasers may be willing to pay a premium (or demand a discount) on the face value of the bond.
Example: A company issues a new bond with a face value of $1m, a coupon of 4%, and a term of 10 years. An investor buys the bond for $1m, and receives 4% each year for 10 years. At the end of the ten years, the investor receives the $1m back.
How can a Bond go down in value?
For most bonds, the coupon rate does not change, so if market interest rates rise after a bond is purchased, then the value of the bond decreases. Confused? Let’s use our example to help explain.
Example: An investor purchases a bond for $1m and receive coupons of 4%. Interest rates then rise to 5%. The investor still receives the coupons of 4% and could hold the bond to maturity. Some may argue the investor is no worse off, however the investor has an opportunity cost.
If another company issues a new $1m bond with a 5% coupon, investors would prefer to own that bond. If the investor tried to sell the bond they own in the open market, purchasers will pay less than $1m for the 4% coupon bond. Therefore the bond will trade at a discount.
Even if the bond is not sold, the discounted price should be used as the fair value of the bond. This is referred to as “mark to market”.
Why are Bonds good investments to have?
Bonds can reduce the overall risk of an investment portfolio, particularly during tough times. This is because bonds often move in the opposite direction to share markets. For example as a result of the Global Financial Crisis, global share prices fell in 2008 by around 37%, US commercial property prices fell by around 33%, but bond prices rose by around 15%.
Want to know more?
Trust Management can provide advice to charities about managing their investment portfolios and setting a risk profile that reflects their investment objectives. This can include the appropriate allocation to bonds, which type of bonds to invest in, and a recommended level of credit risk.
If you have any questions, or would like to know more about managing the risks of investing in bonds, please do not hesitate to contact John Williams on (09) 550 4046.
This paper seeks to provide some detail and explanation about bond investments. The paper aims to provide a basic oversight of the topics mentioned, using simple terminology in easy to understand language. The paper is not intended to be the definitive guide on bonds. We recommend investors seek advice before investing.