Wednesday 26 October 2022 Education (basics),Education

# Bond maths and decision making in switches - most read article for 2022

The current economic times we find ourselves in haven’t been seen for nearly 40 years – and as such have given bond investors (and investors generally) some of the worst returns in that period of time.

Bonds have a key feature not offered by most other asset classes, which is the maturity date. As a reminder this is the date in the future when the bond must be repaid, as long as the issuer is capable of paying.

It is this fixed maturity date, for fixed rate bonds in particular, that makes the calculation of the yield to maturity a simple exercise.

This also enables us to make decisions based on the total yield when moving from one bond to another. As a recap, fixed rate bond prices move in an inverse relationship to the yield; if yields rise, prices fall and vice versa.

The below graphic shows how a bond’s price changes in response to these changes:

There are several bonds which have been affected more than most by the recent increase in interest rates and are now trading somewhere around 80c in the dollar.

If we take one of these, for example, the WestConnex 3.15% 2031 bond, which has an indicative mid-price of \$77.50. This is a yield to maturity of 6.68%.

At the issue yield of 3.15%, the price would be \$100. At 6.68% it is a price of \$77.50.

Therefore, for a holder who bought the bond at a price of \$100, the outcome at maturity will be the same regardless of the current price – a return of 3.15%.

If we assume that the \$77.50 is now effectively invested in a now 9-year bond at 6.68%, it follows that a better investment would be an equivalently rated, shorter bond at a higher yield – such as the new Rabobank bond recently issued, at 7%.

When evaluating a switch from one bond to another, there are usually three considerations to take into account:

1. Credit risk – lower the better (usually using ratings as a measure)
2. Interest rate risk – again lower the better
3. Yield – higher the better, as long as the two above are taken into account.

If you can achieve all three, i.e. lower credit risk (higher rating), lower interest rate risk (shorter tenor) and higher yield, then the switch is usually a slam dunk. Two from three is also usually very compelling.

In this case, we have the same credit rating, a shorter tenor and a higher yield. Yes, the existing bond is a senior bond with a hard maturity and the Rabobank is callable, but the rating takes that into account. Even if the Rabo wasn’t called it is likely the yield would still be favourable to maturity.

The starting point, which is that the \$77.50 of capital came from an initial investment of \$100, shouldn’t be relevant to the forward-looking decision given we can so accurately predict the future returns.

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