How the bond markets work

Debt lies at the heart of today's global economic woes, affecting everything from the eurozone crisis to the fragile British and American economies. So it's more important than ever that investors, who are often more comfortable with equity than with debt, understand how bond markets work.

What are bonds?

A bond is just a tradeable IOU issued by a company (a corporate bond) or a government (a sovereign bond). Only the fact that it's tradeable makes it any different to a conventional loan. Say a government issues a fixed-income 5% bond redeemable (repayable) in four years' time, and the government is looking to borrow (for argument's sake) £100. This is the bond's nominal value. This fixes the annual coupon (interest payment) at exactly £5 (5% of £100). The nominal value is also the amount the government will have to repay the bondholder in four years' time.

However, the nominal value does not dictate the price the government can sell the bond for when it first issues it, nor what the bond will be worth between being issued and redemption. Instead, the market does the job of pricing. Bond prices (like share prices) are influenced by all kinds of factors. However, three are more important than the rest.

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Interest rates

As money market interest rates rise, bond prices will tend to fall and vice versa. That's because the relative attractiveness of a fixed 5% yield varies according to what an investor can get elsewhere. If a bank account pays 2% (£2 on £100, in other words) the bond's nominal fixed return of £5 on a £100 investment is attractive, so demand for it will rise. This will push up the price of the bond (so you'll have to pay more than the £100 nominal value), which in turn drives down the yield. Equally, if a deposit account pays 7%, the nominal 5% return on the bond is less attractive, so the price will fall below £100, driving up the yield.

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Time to maturity

The further you are from the bond's redemption date, the more volatile the price becomes, because there's more risk that interest rates will change while the bond remains outstanding. This is where the term duration' comes in. The maths is fiddly, but in a nutshell, high duration tells you that a bond is more sensitive to interest rate changes than other bonds with lower durations. This isn't a bad thing, as long as you are comfortable with the extra risk.

Default risk

This comes in two varieties. Some issuers are riskier than others (more likely to default, in other words). But even for the same issuer, some bonds are riskier than others, depending on whether or not they are secured against the assets of a business. The higher the risk, the higher the yield investors will demand. One key aspect of perceived risk is the bond's rating.

Credit-ratings agencies such as Moody's and Standard & Poor's are paid to rate corporate bonds (they also choose to rate sovereign bonds for marketing purposes). Their grades run from AAA (the top rating) down to D when an issuer is in default. So the higher the rating, the higher quality the bond (assuming the agencies are getting their analysis right, which isn't a given). Once a bond drops below BBB it loses investment grade' status (the minimum required by some of the big institutions) and becomes junk'.

An early warning signal

Although widely quoted, bond ratings are ultimately just opinions. The real test is what the bond market thinks. That's where spreads' come in. A spread is the gap between two quoted yields, usually between something quite safe and something riskier.

In the case of the eurozone, you can get an idea of how much stress the region is under by comparing the spread on safe' German government bonds to those on risky peripheral' country debt. Say German ten-year bonds are offering a yield of 1.5%, while Spanish ten-year IOUs are offering 6.5% as nervous investors sell up. That's a spread of five percentage points (6.5%-1.5%). This is more commonly expressed in basis points'. A basis point is one-hundredth of 1%, so here that's 500 basis points. The wider the gap and critically, the faster the gap is widening the greater the perceived risk for Spanish bond holders.

How to buy sovereign bonds

When it comes to sovereign debt, we're not keen on developed world government debt. With yields at record lows, it's too expensive. An alternative, which Tim Price of The Price Report newsletter likes, is to buy the debt of emerging nations that have the assets to back their borrowing.

The Wealthy Nations Bond Fund (020-7766 0888) does just that, investing in the debt of countries such as Qatar and Singapore among others. Alternatively, if you have a strong stomach for risk and agree with our cover story that the Italian market looks cheap, then it might be worth considering an exchange-traded fund (ETF) that tracks Italian government bonds.

Barclays has just launched the iShares Barclays Italy Treasury Bond ETF (LSE: SITB). The total expense ratio is low at 0.2%, while the current yield to maturity is around 5%. Do bear in mind that the ETF comes with exchange risk (in the form of euros to sterling), along with all the other risks of buying Italian government debt.

This article was originally published in MoneyWeek magazine issue number 592 on 8 June 2012, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.