willflackster wrote:Can someone explain simply how this works -
I get the principle that a bond paying 5% for example that comes due in one year is worth about £96+/- if interest rates are 5% you get your £100 when it comes due - when interest rates go to 2.% what then happens to the value of that bond - how does it maintain the 5% yield does the bond cost £97.50+/- a year out from repayment. How does it work for say a 5 year 5% bond lifespan is it worth only £78+/-
I read about a bond ladder but not sure how that works and how to construct one for return of capital - any help gratefully received!
In your example the £100 one year bond issued at 5% interest will initially be sold to investors by the issuer at £100 / 1.05 = £95.24 (I'm assuming that there is no risk of default). You buy £100 at this price. Lets assume that one year interest rates immediately fall to 2.5%. The market will price the bond at £100 / 1.025 = £97.56.
You still get your £100 when it matures in one year (so you're getting your 5%) but you can sell the bond now for £97.56 to someone who is happy with 2.5%Your five year bond sold at 5% interest (all paid on maturity) is priced at £100 / 1.05^5 = £78.35. If five year interest rates immediately move to 2.5% the market price rises to £88.39, new buyers are locking into 2.5% but you are already locked into 5%.
The interest rate paid on gilts/bonds is fixed when they are originally sold to investors. Movements in interest rates cause the market price of the bond to move but the payments remain unchanged. So if you bought a 30 year gilt when it was issued at £100 paying 5% interest then you would get £5 per year for 29 years and £105 in year 30 (£100 plus £5 interest). Regardless of what happens to interest rates in the meantime that is what you would get.
If interest rates rise, the market price of bonds falls. If interest rates fall, the market price of bonds rises. Bonds with longer maturity dates are more volatile than bonds with shorter mturity dates. Bonds which pay higher interest are less volatile than bonds which pay lower interest (both bonds have the same maturity dates)
There are a few bonds where the interest and/or capital are not fixed (e.g. linked to the price of oil). Bear in mind that most of the price action in bonds is in response to interest rate movements and changes in the creditworthiness of the issuer.
A bond ladder consists of buying several bonds, with different interest payment dates and maturity dates, to ensure a reasonably steady flow of cash over the term. As bonds mature you buy another bond with a longer date which fits in with your existing profile. For example, an investor splits their money between five different gilts with maturity dates of three, five, seven, ten and fifteen years. When the three year bond matures the investor buys a ten year gilt so the ladder's maturity dates are now two, four, seven, ten and twelve years (i.e. the original bonds minus three years plus a new ten year bond). By staggering the maturity dates you are less exposed to inflation risk and interest rate rises than if you invested in a single long duration gilt (e.g. put the lot in a fifteen year gilt at the start).
Hope this helps.