In their latest exam study article, the Brand Financial Training team take a look at Fixed Interest Securities.
Fixed interest securities are also known as bonds, loan stock and even debt securities. We know them generally as gilts and corporate bonds. In this article we will refer to them generically as ‘bonds’.
Bonds provide a fixed amount of income over a given period of time and repayment of the original capital at redemption.
In very simple terms, a bond is an IOU to the investor from the borrowing organisation, such as the government or a company.
A gilt is a bond issued by the Treasury and a corporate bond can be issued by a company. Both are used to raise money to finance long term expenditure.
Gilts are considered to be less risky than corporate bonds and both are considered less risky than investing in shares, although gilts and corporate bonds are more likely than shares to be affected by interest rates and inflation.
There’s an inverse relationship with bond prices and interest rates; as interest rates fall, bond prices go up and when interest rates go up bond prices fall. The modified duration of a bond helps us to determine price sensitivity by gauging how much the price is likely to rise or fall when interest rate changes happen.
Duration measures how long it takes in years for the price of the bond to be repaid by its cash flows. Let’s say this has been calculated as 3.41 years. We can use this figure and the gross redemption yield to then calculate its modified duration. Let’s assume the gross redemption yield is 4%.
The formula for calculating modified duration is: Duration of 3.41 divided by (1 + the gross redemption yield of 0.04) = 3.28.
This tells us that this bond has a modified duration of 3.28 and so can be expected to undergo a 3.28% movement in price for each 1% movement in interest rates.
If the bond had a current price of £108.28 and interest rates rise by 1% then we can expect the bond price to fall to: £108.28 – (£108.28 x 0.0328) = £104.73
Yield Curves
A yield curve is a line that plots the yields – or the interest rates – available on bonds against their maturity dates– either those offered by the government or companies.
To draw a yield curve all you do is plot the number of years along the x-axis and the bond redemption yields on the y-axis then put a dot for as many bonds as you can find and join them together.
A yield curve generally slopes upwards from left to right because longer dated bonds usually have higher interest rates as demanded by the investor for the risks they’re exposed to over a longer period of time and shorter dated bonds offer the lowest returns. This is known as a ‘normal’ yield curve. A normal yield curve shows that investors expect the economy to grow at a normal pace without any major changes in inflation.
The important yield curve to watch is those for gilts as these influence interest rates on mortgages and bank loans.
Occasionally you might get an ‘inverted’ yield curve which slopes downwards. They are rare but should not be ignored by investors. This is when shorter term yields are higher than the longer term yields which begs the question of why longer term investors would accept lower returns than short term investors who take on less risk.
The reason is that inverted curves can be an indication that the market is expecting interest rates to fall and yields on longer maturities to become even lower in the future (so investors lock in before they fall even lower which increases the price and reduces the yield); although rare an inverted yield curve can be associated with economic slowdown or worse-case scenario, recession.
When short term yields are closer to long term yields we get what’s called a flat yield curve; in other words the yield on say a 10 year bond is the same as that of a 30 year bond – this can indicate stability in terms of inflation and interest rates.
Yield curves give us an idea of what to expect from investments and borrowings over different timescales as they help gauge the current and future strength of the economy. Have a look at the slope of the curve too; the greater the slope the greater the gap between short and long term rates.
The Bank of England estimates UK yield curves on a daily basis.
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