This week’s article continues on the subject matter of bonds.
Most bonds have a fixed interest component that pays out the same amount, usually every six months, for the life of the bond.
This, naturally, means that bonds, especially longer dated bonds i.e. five years, ten years and upwards are poor stores of value in an inflationary environment.
To counter the eroding effects on inflation a number of governments and related issues of bonds i.e. municipalities issuers inflation indexed bonds. This type of bond may, for example, have its coupon rate i.e. interest rate adjusted every year to compensate investors for the current inflation rate plus, say, two percent. Therefore if inflation rates were at 3% investors would be paid a total of five percent.
These inflation indexed bonds are very popular with investors although there is usually the old grumble about governments understating the real inflation rate.
The coupon rate i.e. interest rate on a bond varies greatly and there are a whole range of bonds that are termed high yield. High yield bonds are to be found among countries that issue bonds where the history of the country is one of more than average inflation rates. The other type of high yield bonds are those issued by companies and other entities i.e. electricity utilities with less than stellar credit ratings.
However, this is not always the case; electrical utility such as South Africa’s Escom, has a good credit rating. The risk is not primarily in the issuer but in the currency i.e. the South African Rand. Risk is a difficult concept; it often relates to the level of volatility rather than outright risk of default. Where investors buy bonds in other currencies there is always the risk of losses when converted to the investors “home” currency.
Individual investors often make the mistake of chasing yield, meaning that bonds with high yields are vastly preferred to those with low yields. This is often due to greed and lack of care in examining why the difference exists.
Many investors in bonds avoid actually buying individual bonds and simply invest in a bond fund.
Naturally, a bond fund has extra costs compared to simply buying a bond. This cost is hopefully more than compensated by the added value a fund manager can bring to the portfolio. There are many different types of bond funds ranging from those which only invest in bonds of a very high credit rating to those who specialize in junk bonds. The latter is a term for bonds that are below investment grade credit rating.
In addition, investments in emerging market debt are also popular. This then means that the bond fund manager is responsible for multiple tasks such as selection of individual holdings, political, economic, currency and market factors. In large bond portfolios the managers may also, where deemed prudent, purchase credit default swaps. This is basically purchasing insurance against a default by a bond issuer.
Bonds are often the sole or major component on an investment fund which is labeled “cautious” and is almost always present in a fund which is labeled “balanced”.
Almost everybody had heard of stockmarket crashes, property market crashes, etc. but who has ever heard of a bond market crash? Well, they do exist but they are relatively rare and any newspaper carrying a headline “Bond Market Crash” is unlikely to find that many of their readers even understand anything about the subject matter.
The last significant bond market crash started on the 24 February 1994. This was caused by a global bond market rally that had simply carried on far too long. Worries about higher economic growth and rising inflationary pressures suddenly infected world bond markets and a stampede for the exit doors caused bond prices to collapse. This was not just a single day of falling prices, the 24th February was the start of what was referred to as a rolling market crash which extended until December 1994.
During March of this year it appeared that some sort of resolution had been reached to tackle Greece’s debt problems. The Euro zone countries reached a loosely worded accord that would see them in some sort of combination with the IMF (International Monetary Fund) came to rescue Greece if necessary.
Reports from Bloomberg and other sources now reveals that Greece is about to try and raise billions of dollars in American bond markets. It also is reported that Greece is trying to avoid any involvement with the IMF as it fears the stringent rules and conditions that will apply.
Rather, Greece wants to have the Euro zone countries involved as it knows with them that it can virtually set its own terms.
Until this matter is settled it is going to undermine the value of the Euro.