Bonds – my first look .. confusing

 

Are bonds just a means to loose money (slowly) ?

 

I have really only thought of bonds (especially those of specific duration) as being rather like an annuity. Pay out a chunk of money and receive an annual income that is usually not inflation matched.

 

If you buy a 10 year bong paying 4.5% yield then for every £1000 payed you will get £45 every year. The differences are 2-fold to an annuity though:

 

1. Unlike an annuity, the capital is at risk
2. Unlike an annuity, providing there is no default, at the end of term the capital is returned

 

The one part missing is inflation. if annual inflation were 2%, then in real terms the capital returned would be worth £820 and the yield received would be worth around £37. So effectively an 18% drop in value and purchasing power.

 

 

If I invest say £10,000 in a bond at par (100) for 10 years giving a 5% coupon a year then after 10 years I get my £10 Back and in the meantime I have had £5K of coupon so get an effective annualised return of 4.1%.

 

(£5000/£10000 = 50% return over 10 years is equivalent to 4.1%pa compounded).

 

Of course what this does not include is the real terms value of the cash both received in coupon and capital returned. Factor in that using an inflation rate of 2% pa and the real annualised return is more like 2.6%.

 

Does not sound too bad if the bond is low risk and you get the capital back !!

 

 

 

What about the annual Risk Free Rate of Return (RFRoR). In investing, there is an assumed zero-risk rate of return. This is essentially the return that can be obtained from treasury bonds (normally I believe 10 year bonds).

 

For the UK is 2017 and 2018 the RFRoR was 2.2% and 2.0% respectively.

 

So for tying my capital up I earn around 0.5%pa for the risk of looking capital. That does not sound all that good.

 

What if I pick a bond so 10% below par, say 90 not 100 effectively giving me more bonds for my money. Well, my annualised rate goes up to 3.7% (1.6% above the RFRoR).

 

 

But if I pick a bond 10% above par (at 110) then my annualised rate is 1.6%, or to be more precise 0.5% below the RFRoR. In other words I carry risk for no reward and why was it so cheap in the first place ?

 

The RFRoR differs for each country. For example (www.statista.com) has December 2018 rate for Greece as 4.3% and Germany as 0.25%. I am not sure how anyone could view Greece as risk free and the 4.3% paid out on government bonds is surely not sustainable. Germany on the other hand offers 0.25% as it is seen as essentially negligible risk.

 

And hear in lies my problem. As I start to read up and understand Bonds. I just don’t get why you would tie up money that looses cash in real terms annually, although I can sort of understand as part of a retirement portfolio having a level of predictability is an advantage , but is  loosing money at a definable and predictable rate enough to allow 30+ year planning.

 

This and finding that Bond values are very closely linked to interest rates in a negative way is even more confusing. As interest rates rise, the value of bonds falls (sort of obvious in a way) so is the only way to make money in a bond market when interest rates fall I wonder ?

 

This and the distorting effect of quantitative easing makes it all look even more complicated.