Guide: investing in bonds

Setting money aside is a key building block for a retirement with no financial worries. Investing money on the capital market is essential for this. In addition to equities, the various types of bonds can also play an important role in the investment mix. This article explains what bonds are and introduces everything you need to know about them.

Inhalt

1. Definition and alternative terms
2. Types of bonds
3. How they work
4. How they move with the economic situation
5. Advantages and disadvantages
6. Investing in bonds

Definition and alternative terms

Everyone needs money. Countries need capital to build infrastructure or finance their budgets. Companies need new production facilities, machines or want to tap into new markets.

One way of obtaining the capital needed is to issue bonds. The issuer takes on debt, i.e. a loan. By purchasing a bond, the buyer makes the corresponding amount available to the debtor; the bond is a debt instrument that documents the holder’s right to regular interest payments in exchange for providing the capital and repayment at the end of the term.

Bonds are therefore securities with a fixed coupon and a fixed term. They are also referred to as fixed-income securities. In addition, there are common synonyms such as “debenture” and “fixed-interest security” (see Excursus).

Excursus: a brief history of bonds

According to Wikipedia, the first bonds were issued in the early Middle Ages, mostly as war loans. An early form of government bond was a loan taken out by Doge Vitale Michiel II in Venice in 1156. He borrowed money from Venetian citizens at an interest rate of four percent.

Every trading day after issue, fixed-income securities are traded on the capital market, where private and institutional investors buy and sell them. The price of a bond is determined by supply and demand, which in turn are determined by various influencing factors such as monetary policy, interest rate trends and the macroeconomic environment.

According to the data portal Visual Capitalist, bonds worth USD 133 trillion were listed around the world in 2022. By way of comparison, according to the data portal Statista the global stock market was worth USD 98.5 trillion.

Difference compared to mortgage bonds

Much like a fixed-income security, mortgage bonds have a fixed term and offer regular recurring interest and repayment of principal at the end. The difference lies in the fact that mortgage bonds are covered. This means that they are backed by collateral. In Switzerland, mortgage bonds are subject to very strict rules:

[…] The Swiss Mortgage Bond Act of 1930 provides a strict framework for issuing mortgage bonds in Switzerland. They are used to raise long-term funds to finance banks’ mortgage business. The Swiss Pfandbrief® (mortgage bond) is a security with special collateral.

In Switzerland, mortgage bonds may only be issued by the two mortgage bond institutions set out in the Swiss Mortgage Bond Act. In Germany, credit institutions need a licence from the Federal Financial Supervisory Authority (BaFin) to carry out mortgage lending business.

The collateral used to cover the mortgage, i.e. the mortgage borrower and the property pledged (which may be a building or plot of land) are ultimately liable for the mortgage bond. This means that mortgage bonds offer a very high degree of security and are even deemed suitable for trustee investments.

Bonds vs. shares

Although both shares and bonds are traded on the capital market and their price is determined by supply and demand, otherwise they differ significantly. This becomes particularly clear when you compare a corporate bond with a share.

In the case of a corporate bond, buyers become creditors. They give the company a loan and the money raised by issuing the bond counts as debt. If, on the other hand, an investor buys shares in a company, they become a co-owner. The shares therefore count as equity.

Unlike fixed-income securities, shares do not have a fixed term. However, if the company pays dividends, shareholders receive a share in the profits and so likewise a regular distribution.

However, while a bond has a fixed coupon payment, the dividend is not guaranteed. If things are going badly for a company, it can be reduced or stopped altogether. The dividend is therefore not the same as the fixed interest rate on a bond.

Other differences are that shareholders have the right to attend and vote at the Annual General Meeting. They also have a right to subscribe to newly issued shares. In the case of shares, there is also no right to repayment of the capital invested. If the company goes bankrupt, bond holders are given priority over shareholders.

The different types of bonds

Government bonds

The most common form is sovereign bonds, i.e. bonds issued by countries such as Switzerland, the USA or the Federal Republic of Germany. The best-known include German government bonds (Bunds) and US government securities (Treasuries).

Bonds are also issued by the Swiss Confederation or the individual German federal states; these are also classified as government bonds in the broadest sense. Investors can obtain information on government bonds in Switzerland from the Swiss National Bank.

Corporate bonds

Companies of all kinds also act as issuers of bonds. In addition to medium-sized companies, these also include companies from the blue chip Swiss SMI index such as Nestlé, Roche, Novartis, Sika and Swisscom. Bank bonds are issued by banks such as the Swiss Raiffeisen banks, Migros Bank, ZKB and UBS.

Investment grade vs. high yield

Corporate bonds can be divided into investment grade and high yield. The former are bonds issued by issuers with better creditworthiness, which is reflected in a good to very good rating (see also the section on ratings). They generally pay lower interest as they are considered to be less risky.

In contrast, issuers of high yield bonds have lower credit ratings. They are therefore more likely to default. As high yield bonds are riskier from an investor’s perspective, they have to offer a higher rate of interest as compensation.

Special bonds

Convertible bonds

Convertible bonds are hybrid products between equities and bonds. The securities have a bond component, i.e. they function like a fixed-rate corporate bond repaid at par value at maturity.

In addition, they include the right to purchase the issuer’s share at a predetermined price instead of repayment at nominal value. This means that investors benefit from an increase in the price of the underlying equity, while the bond component offers downside protection.

Zero coupon bonds

Zero coupon bonds or zero bonds do not have an interest coupon and therefore offer no current interest. Investors only receive the interest income at the end of the term, when the bond is repaid.

Inflation-linked bonds

These bonds are typically issued like sovereign government bonds and provide protection against inflation. Specifically, their repayments and annual interest payments are linked to the inflation rate, i.e. to the national consumer price index (CPI).

If the CPI rises, the interest payment and the nominal value of the bond also increase, protecting against the loss of purchasing power of the money invested. Conversely, in the event of deflation, i.e. in an environment of falling prices and a corresponding decline in the CPI, there is a risk of falling coupon payments.

Dividend-right certificates

This is a special type of bond with elements of both equity and debt. On the one hand, a dividend-right certificate also offers the full repayment of capital at the end of the term. On the other hand, as with shares, investors have the opportunity to participate in the company’s success via a profit distribution.

How bonds work

Nominal value – below or above par

Bonds are generally issued at their nominal value of 100% and are also repaid at this price. If the bond is quoted at 100%, this is referred to as “par”. If it trades above this, it is "above par"; if the price is below, the bond is trading "below par".

Although the price of a bond is subject to changes over time due to supply and demand, the level of market interest rates also influences the price performance.

But why does the price of a bond fall when market interest rates rise and vice versa? Assuming the general level of interest rates increases, the value of bonds that have been on the market for some time will decline because their coupon payment is now lower than the yield on the new bonds coming on the market. As a result, the price of these older bonds has to fall if the general level of interest rates rises. The reverse is true if the general level of interest rates falls.

Bond yield

Bond investors also have to differentiate between the yield on a bond and its interest rate. This is because the bond yield is made up of the current fixed coupon payment until the end of the term, the current price of the bond and its repayment price.

If a bond is trading below par but is repaid in full, there is a price gain to maturity in addition to the current interest. If it is above par, price losses are incurred to the end of the term, which have a negative impact on the yield.

Term and its impact on yield

As already explained, bonds have fixed terms or maturities. A rough distinction is made between short-term bonds with maturities of up to three years, medium-term bonds or securities with an average maturity of five to seven years and long-term bonds with maturities of more than seven years.

Depending on their maturity, fixed-income securities react very differently to changes in the general level of interest rates. As a general rule, the longer the term, the greater the price loss if interest rates rise. So if you expect interest rates to rise in the near future, you should focus on shorter maturities. Conversely, when interest rates fall, price gains are greatest for long-term bonds.

In addition to maturity, bonds also have what is known as duration, which is again expressed in years. This describes the period for which capital is tied up; unlike the residual term of a bond, it is calculated taking into account interim interest and payments of principal. For this reason, duration is usually slightly shorter than residual term.

Creditworthiness and rating

The creditworthiness of the issuer is a key factor when investing in fixed-income securities. As a rule, the creditworthiness of issuers is determined by rating agencies. The largest and best known are Standard & Poor’s (S&P), Fitch and Moody’s.

S&P’s top rating is AAA (triple A), held by Switzerland or the Federal Republic of Germany, for example. Issuers rated AAA to BBB are classified as investment grade.

A rating table with an overview of the ratings of different agencies can be obtained, for example, from the Frankfurt Stock Exchange.

Below BBB, i.e. from BB downwards, speculative grade begins. Generally speaking, the worse the rating, the greater the risk of default. Issuers of high yield bonds have to compensate for this risk by paying higher interest rates in order to raise debt by selling bonds in the market. From an investor’s perspective, this means they are buying a higher interest rate with a greater risk of default.

It is also important for investors that ratings equate to certain historical probabilities of default. For issuers with the top AAA rating, the probability of default is zero per cent over one year and 0.1% over four years. For issuers with a BBB rating, this figure rises to 1.6% over a four-year period, and for borrowers with a BB rating, it is as much as 9.4%.

Bonds and how they move with the economic situation

A key factor influencing fixed-income securities is the monetary policy of central banks, in particular those of leading economies such as the US Federal Reserve, or Fed for short, and the European Central Bank (ECB). They usually have as their primary objective price stability in their respective currency areas. They steer these using the base rate.

If inflation rises above the 2% target, they raise base rates. In the opposite situation, they cut them. This in turn influences the general market level of interest rates and hence the yield on bonds as well as – as explained above – their price performance.

There is therefore a close linkage with economic trends. As prices tend to rise during an upswing or boom, central banks are more likely to raise interest rates to prevent the economy from overheating with rising inflation. In a recession, however, prices fall and central banks then cut interest rates.

Advantages and disadvantages of bonds

Safe government and corporate bonds

Due to their fixed interest coupon, fixed-income securities first offer the advantage of regular and predictable returns and are therefore of interest to all investors looking for a regular stream of income. However, investors only receive this as long as the issuer remains solvent.

For this reason, investors seeking ongoing returns should prefer safe and stable government bonds with the highest possible rating. These offer another advantage in a balanced portfolio with equities:

as they generally do not perform exactly in line with the equity markets and mostly exhibit low volatility, in a normal environment they offer a diversification effect compared to equities.

Safe bonds in a portfolio can help to reduce risk if, for example, the equity market crashes. Government bonds with the highest credit ratings thus offer security.

But even safe bonds are not risk-free. They can also experience occasional sharp price losses if interest rates and yields rise massively, as in 2022. The real bond yield must also be taken into account, i.e. the yield minus inflation. If inflation exceeds the yield on a bond, the capital invested loses value in real terms. And finally, even for debtors with a high credit rating, defaults cannot be completely ruled out.

Excursus: the classic 60/40 portfolio

A well-structured portfolio includes both equities and bonds. The traditional split between the two asset classes is 60% equities and 40% bonds, generally with a preference for safe government bonds from Switzerland, the US or Germany.

The idea behind this is that equity prices tend to fluctuate more than those of the government bonds mentioned, as can be seen from a comparison between the VIX volatility indices measuring the expected fluctuation of the leading US equity index, the S&P 500, and the MOVE, which measures expected fluctuations in US government bonds.

Theoretically, bonds should stabilise the portfolio, especially in difficult market phases, while the equity component provides long-term returns.

Whether this sort of split still made sense during the period of low interest rates seen in recent years is debatable. Ultimately, however, asset allocation is closely linked to the individual investor’s risk tolerance and investment objectives, so the optimal portfolio allocation may be different for each individual investor.