A few years ago, the unthinkable happened: interest rates dipped below zero worldwide.
The 12-month Euribor – the money market benchmark rate for interbank term deposits (in euro) with a fixed maturity of up to one year – also dropped below zero in February 2016. This had a major impact. In this "new interest rate era," first-time home buyers saw their dream house – due to lower financing costs – come within financial reach sooner, and existing homeowners were able to refinance cheaply.
On the other hand, savers received little or no interest on savings accounts but instead had to pay interest (sometimes) on higher savings balances. Interest rates on bonds – both government and corporate – also fell sharply. That boosted the prices of existing bonds, but new loans offered ever-lower coupon rates. Low interest rates made the search for bonds that could add value to investment portfolios increasingly challenging.
How different the world looks today. Globally, interest rates rose sharply in a relatively short period of time. That led to sharp falls in bond prices in 2022. In addition, new loans are again offering coupon rates we haven't seen in years. This presents opportunities for investors. Before addressing where to find them, first a quick refresher on what bonds are and some important product features you need to know.
What are bonds? Financial markets offer a variety of investment products. One of the largest categories is bonds. A bond is a loan issued by a company or government. With a bond, you lend money for a certain amount of time in exchange for interest. It is a debt instrument, and, unlike stocks, you do not become a co-owner of the issuing institution. Bonds are tradable daily on stock exchanges and over the counter (OTC). There are several reasons for issuing bonds. In many cases, a company or government wants to raise capital to realise growth plans. Sometimes a loan is issued to pay off another loan.
Characteristics of bonds The amount the government or company wants to raise with the loan is called the face value. This often involves large amounts, sometimes more than € 1,000,000,000. Therefore, this amount is cut into pieces of, say, € 1,000. These pieces are called denominations. Once in possession, you usually receive coupon interest on the denominations once a year, on the coupon date. Some bonds pay interest every six months or quarterly. Other bonds known as zero-coupon bonds, don’t pay interest but are offered at a discount.
The amount of coupon interest depends on the market interest rate, the term of the bond and the creditworthiness of the issuing institution. Typically, the quality of the issuing institution, the higher the rating, the higher the interest rate, the lower the creditworthiness of the issuer, and the longer the term of the loan, the higher the coupon rate.
There is an inverse relationship between interest rates and bond prices. If market interest rates rise, bond prices generally fall. If market interest rates fall, bond prices usually rise. Bond prices are also affected by the creditworthiness of the issuing institution. If the latter is in doubt, this can put considerable pressure on bond prices.
Why invest in bonds?
The main reason investors buy bonds is relative safety: if the issuing institution does not go bankrupt, you will get your money back at maturity. In addition, you will receive coupon interest at fixed intervals. This is nice if, for example, you want to draw income from your assets to supplement your pension.
Another reason to invest in bonds is that they fluctuate less than stocks. They are a kind of shock absorber within a portfolio.
Risk and diversification Risk and return go hand in hand. A company, as well as a government, may face a downturn. As a result, the price of the bond may drop significantly. In addition, the interest payment may possibly be skipped. And in the worst case, the issuer may go bankrupt. That makes repayment uncertain.
To reduce the risks, it is wise to include bonds from different sectors, or even geographies, in your portfolio. So, don’t look only at bonds from banks and insurers, but also, for example, a bond from a brewery or tech company. Also, don’t invest only in emerging market bonds, but diversify by investing in bonds from developed countries as well. You can also achieve this diversification by investing in a bond (mutual) fund or bond ETF.
Where to find bonds? Within your account, you can easily find interesting bonds from all over the world. Just select ‘Markets’ and then ‘BO Bonds’.
