Whether it’s building infrastructure, growing a business or investing in equipment, governments and corporations often need to raise funds for their operations. Issuing bonds is a common way to raise the money they need.
What is a bond? It’s an IOU from a corporation or government to an investor. Issuing bonds means that the face value of the bond (known as the principal) must be repaid on a due date (maturity). Investors will also earn interest on the bond, otherwise known as the coupon. The coupon is calculated annually as a percentage of the bond’s face value.
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People choose to invest in bonds for “a perceived predictability in future cash flow,” says Shailesh Kshatriya, director of investment strategies for Russell Investments Canada. “If the bond is paying 5%, 10% or whatever the coupon rate is, your belief is that there is a high degree of predictability and certainty that you will get that cash flow over time.”
There are four major types of bonds, each of which have their own market:
- corporate bonds, which can be used to finance operations or business growth;
- government bonds, which repay the face value of the bond on the maturity date with periodic interest payments;
- municipal bonds, which are issued by local governments to fund projects; and
- mortgage bonds, which refer to pooled mortgages on real estate properties.
Though bonds are often thought of as safe investments, bond prices can fluctuate for several reasons. We look at each.
A rise in interest rates generally means bond prices will fall and vice-versa, otherwise known as an inverse relationship.
Interest rates play a role in determining the coupon rate—what Kshatriya calls “the predictable cash flow”—and future bond prices. He says it’s important to consider current interest rates and where they may head in future. Forecasting interest rates includes looking at where they are in relation to the business cycle.
“Are we in the early stages of a business cycle, the middle stages or in the late stages?” asks Kshatriya. In an early stage, interest rates have typically been reduced to help the economy grow again. Rates tend to be steady during the middle stage. The late stage means rates are rising to prevent inflation during an economic recovery.
Changes in interest rates affect the market value of the bond you hold.
For example, “if interest rates rise to 4%, the bond with a 3% coupon is no longer going to be attractive because participants could just go get a bond with a 4% coupon,” says Catherine Heath, vice-president, portfolio manager and fixed income analyst at Leith Wheeler.
That would decrease the demand for such bonds, leading to a price drop in the secondary market: you would get a lower price for it if you wanted to sell it instead of holding it to maturity.
“The bond with a 3% coupon is going to be discounted by the market because of its lower interest rate,” sums up Heath.
The inflation rate also has an inverse relationship with the price of bonds. Any rise in inflation means the return you’ll earn on your bond will be worth less in current dollars when the bond matures.
“Inflation is the enemy for bond investors because it erodes purchasing power,” says Kshatriya.
These reports include the monthly numbers for employment, inflation and GDP growth.
“You have economists forecasting what those numbers are going to be, so the big thing that moves the bond market is when those numbers are reported,” says Joey Mack, director of fixed income at GMP Securities. “If those numbers are a lot different than what economists were expecting it to be, you’ll get a move in the market.”
Positive economic news, such as stronger employment data, will generally cause bond prices to fall, while negative news, such as lower housing starts, will generally cause bond prices to rise. That’s because investors often turn to bonds during times of uncertainty, increasing demand when economic indicators are poor.