Bonds aren't actually that boring

I’ll pay you back next week. I promise.” – We’ve all been there: a friend is short of cash and needs to borrow some money. A verbal agreement is a financial obligation and is just as binding as a written contract.

This type of agreement has always been important in financial transactions, and indeed the motto of the London Stock Exchange is “My word is my bond”. Bonds are a promise to repay borrowed money and make payments of interest on it.

More or less than 100

Today, the handshake to seal the promise takes place electronically, and the details are set out in bond prospectuses that can run to hundreds of pages. Another key feature of bonds is that the principal amount remains the same throughout the term to maturity, and usually the payment of interest does too.

In a bond issued at the beginning of May, for example, the insurance company Helvetia Baloise promises to pay a coupon of 1.5 per cent each year on the total borrowed amount of CHF 225 million for ten years, i.e. until 12 May 2036. The total is divided into tranches of CHF 5,000, which is therefore also the minimum investment.

Unlike with equities, investors know exactly what return they will achieve at the time of purchasing the bond. Provided the Helvetia Baloise bond is held until the term to maturity, this amounts to ten times the interest. Added to this is any difference from the redemption amount. If the bond is purchased at 99 per cent, an investment of CHF 10,000 (two bonds at CHF 5,000 each) yields an additional CHF 100 (excluding fees). Conversely, the return decreases if the bond is purchased at more than 100 per cent. Bond prices are therefore quoted as a per cent, not as absolute figures. And to make comparisons easier for investors, data portals often also show the bond’s yield to maturity.

But why is it worth paying more than 100 per cent at all – that is, more than will be repaid at term to maturity? Just as individual news items move the market for equities, so too do conditions in the interest rate market change. And bond prices react to these changes. Specifically: if interest rates fall in the Swiss franc market – for example, following an interest rate cut by the Swiss central bank – then older bonds with higher interest rates become more attractive. And because demand for them rises, the price also goes up. Conversely, the yield falls, reflecting the lower interest rate level. An increase in interest rates works in the opposite way. Bond prices therefore also fluctuate, but much less so than equities.

Security comes first

As with a friend, what matters with bonds is how secure the repayment is. This is all the more important for debentures issued by companies with maturities of five or ten years. Rating agencies provide assistance here by assigning a grade for this credit risk based on the debtors’ balance sheets. This risk also exists with government issuers that borrow money for 10, 30 or 50 years – albeit on a much smaller scale. Governments go bankrupt less often than companies.

Among professionals, bond investors can be easily distinguished from equity investors: the former focus primarily on the risks. The latter are optimists driven by the prospect of making a profit. For your own portfolio, the key is a mix of the safer, regular income from bonds and the potential gains from equities.

Legal notice: You can find the legally required information on financial analyses at https://www.vpbank.com/en/legal-notice