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Explainer

Explainer: Everything you've always wanted to know about bonds but were afraid to ask

The National Treasury Management Agency auctioned €1.5 billion of Irish government bonds last week.

LAST WEEK, THE National Treasury Management Agency (NTMA) raised €1.5 billion due in 2029 and 2050 at an auction of Irish government bonds, its fourth issuance of the year.

The sale was part of the agency’s efforts to boost borrowing from a pre-pandemic target of €10 and €14 billion in 2020 to a revised figure of between €20 billion and €24 billion to cover costs associated with the coronavirus crisis.

In just one auction on 7 April, the NTMA raised €6 billion, its largest bond sale since October 2009.

Governments across the world are doing the same thing for roughly the same reasons. Earlier this week, Italy raised a record €22 billion from its largest bond sale ever.

Who actually buys bonds?

Government bondholders tend to be overwhelmingly private, foreign investors and institutions.

On its website, the NTMA provides a breakdown of exactly who bought the bonds issued on 7 April and where they came from.

“The main investor categories”, it explains “were asset managers (36%) and banks and intermediaries (36%), followed by pension & insurance (10%), central banks and official institutions (10%) and hedge funds (8%).”

Around 84% of the buyers were from overseas, mostly from other Eurozone countries.

Government bonds are attractive to investors because they are often considered a lower risk punt than, for example, betting on certain publicly traded companies.

So in March, when coronavirus panic was spreading throughout global markets as lockdown measures were being rolled out worldwide, money was flowing out of stocks and into bonds, particularly ones issues by countries like Germany and France.

How does it all work? 

Bonds are an IOU from a government to a private investor. They have three main components — a fixed maturity, a price or ‘face value’ and an interest or ‘coupon’ rate.

When an investor buys one, the government issuing the bond promises to pay back the original price of the bond at its date of maturation, some specified time in the future.

Bond maturities can range between three months and three years for short-term bonds, two to 10 years for intermediate bonds and between 10 and 30 years for long-term bonds.

So what’s in it for the investor? 

On top of the principal or ‘face value’ of the bond, the government agrees to fork over yearly interest payments at a fixed rate — the coupon rate — of interest.

So if you buy an Irish government bond at a price of €1000 with a set coupon rate of 10%, you would receive interest payments of €100 per year.

What are bond yields?

For whatever reason, investors like private banks or hedge funds might not want to wait until a bond reaches maturity before reaping their reward. To cash in, they can sell their bonds on ‘secondary bond markets’ at prices determined by the market.

This is where bond yields enter the frame.

The key thing to understand is that the price of a bond can go up and down on secondary markets based on a number of factors, for example, if a country’s public finances deteriorate or if investors expect interest rates to fluctuate in the future because of changes in central bank policy.

Yields measure what the return to an investor would be if they bought a bond — issued by the government last week, last month or last year — at current market prices.

They have an inverse relationship with bond prices — as prices go down, yields go up and vice versa.  

So, if a bond that was originally sold by a government for €1,000 drops in price on secondary markets to €750, its yield increases from 10% to 13% based on the fixed sum of €100 that the government agreed to pay at the outset.

The NTMA’s next bond auction is set for 12 June. 

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