Bonds and Convexity Explained

Spotlight: Bonds and Convexity Explained

Bonds function similarly to bank loans. When you take a loan from a bank, there is a set deadline by which the loan must be repaid, and interest is charged on the outstanding loan amount until it is fully paid back. With bonds, instead of repaying the loan amount in instalments, there is an agreed-upon maturity date. At the maturity date, the bond issuer repays the bond principal (the amount loaned to the bond issuer) in full. During the bond's lifespan, the bondholder receives interest payments, (usually every few months or twice a year), which are known as coupons.
 
Interest rates (or yields) and bond prices have an inverse relationship i.e. when interest rates go up, the prices of bonds go down and vice versa. As interest rates rise, the present value of the cashflows you receive from holding a bond (coupons and principal) will fall. In effect, the coupons on bonds become less attractive relative to the interest earnt on cash, such that investors demand a lower price for the bond so the overall profits from the bond (coupons + difference between purchase and principal) offer an appropriate return. The chart below shows an illustrative example of what a bond cashflow profile looks like from an investor’s perspective – the investor commits a lump sum at the outset (the purchase price) and then receives interest at set intervals, with interest and principal repaid at the bond’s maturity.


 
The amount that a bond’s price changes due to changes in interest rates, i.e. the interest rate sensitivity, is known as “duration”. The higher a bond’s duration, the more its price will fluctuate with changes in interest rates. Time to maturity and the coupon rate are two factors that can affect a bonds duration.
 
However, duration alone does not explain the inverse relationship between bond prices and interest rates (yields). The relationship is not linear (one for one), as shown in the chart below and can be explained by a concept known as “convexity”, which reflects the fact that bond duration will change as interest rates change, therefore affecting the sensitivity of the bond’s price to interest rate changes and driving the non-linear relationship. In practice, when bond yields are high (i.e. bond prices are low) any subsequent increase in yields will have a reduced impact in downward price movements, thus offering support to an investment portfolio as market downturns worsen. This is “downside convexity” and offers protection precisely when it’s needed during market declines. Upside convexity works in the opposite way. So, at low yields, subsequent falls in yields/interest rates can result in increased price movements. Bonds can therefore provide a valuable tool for investors seeking to benefit from significant market upswings without committing excessive capital to risky assets or investment strategies.

 
Bonds may not offer the highest returns but certain types like gilts (UK government bonds) tend to provide more favourable returns compared to the interest rates offered on cash savings, for example. This is because the maturity dates for gilts tend to be further out in the future (as compared to savings accounts) and investors are usually (but not always) compensated for this “term premium”. As a result, gilts are appealing to investors seeking relatively stable investments without taking on high levels of risk. There are also tax advantages to be had with gilts, as the bondholder is only subject to income tax on the coupons received, but no capital gains tax on any capital increase between the purchase and sale price of the bond. With higher interest rates, gilts currently offer value to investors when compared to historical levels. (UK 10 Year Gilt yield was 4.2% at 30th November 2023, compared to 0.3% at 30th November 2020, source FT). In our view, this could be an appropriate time for investors to consider making an investment or topping up an existing portfolio. To learn more please speak to your atomos portfolio manager or financial advisor.

The noise

• Eurozone inflation fell more than expected in November, from 2.9% in October to 2.4% as energy prices continued to log significant year-on-year declines, down -11.5% from November last year. Underlying price pressures have also eased more quickly than forecast, with core inflation (excluding food and energy), the data point more closely scrutinised by the European Central Bank (ECB) dropping from 4.2% to 3.6% on a dip in services prices. Despite investor optimism around interest rate cuts, the ECB’s explicit guidance points to several more quarters of record-high interest rates.

• ​Greece will be repaying €5.3 billion of loans owed to euro zone countries ahead of schedule next month, and will work to achieve the same feat next year per the Greek finance ministry. These loans were provided to Greece during its decade-long debt crisis which began in late 2009, with over €260 billion lent by the International Monetary Fund (IMF) and other eurozone countries. Since implementing tough austerity measures (economic policies that look to reduce public debt) in exchange for their bailout, Greece has accumulated a liquidity buffer of more than €35 billion due to higher-than-expected tax revenues and strong growth.

• Currently on track to install up to 230 gigawatts of winds and solar energy capacity, China is leading the global renewables market. This is over double the new renewable energy capacity installed in the US and Europe combined this year, as the world's biggest carbon emissions emitter (31% of world emissions in 2021 per Global Carbon Atlas) works towards its 2060 carbon neutral target. The cost of wind and solar in China falling as a result of falling domestic interest rates, lower energy costs, and intense price competition among domestic suppliers has helped drive capacity expansion. Per data from the Statistical Review of World Energy 2023, non-renewable energy still accounts for over 80% of China’s energy consumption.

The numbers

GBP Performance to 30/11/2023

Source: Bloomberg, data as at 30/11/2023

The nuance

Following a disappointing few months for markets, equities and bonds rallied in November following positive economic data and a clearer picture that central banks are done raising interest rates. The often mentioned “soft landing”, a scenario where a central bank is able to successfully raise interest rates to curb inflation without sending the economy into a recession, is seen as more and more likely and contributed to the best month for equities in three years.

The US economy grew 5.2% in the third quarter of 2023, revised upwards from the initial estimate of 4.9% defying recession warnings. The fastest pace of growth in almost two years has likely exaggerated the health of the economy. There are no dark clouds on the horizon, but growth is cooling. Job growth slowed in October and the unemployment rate rose to a nearly two-year high of 3.9%. The GDP report from this week also confirmed that inflation was trending lower. The US Federal Reserve could find themselves in a goldilocks like situation, inflation is trending lower and still consumers are spending, but at a slower pace. The Fed could end its rating-hiking cycle without much pain inflicted on the economy.

All investment views are presented for information only and are not a personal recommendation to buy or sell. Past performance is not a reliable indicator of future returns, investing involves risk and the value of investments, and the income from them, may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.

Any views expressed are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by atomos. Any expressions of opinion are subject to change without notice.