Bond yields are rising: what is important for buyers to know?

While there has always been a demand for bonds among investors as it is considered a relatively safe, conservative and less risky form of investment, the stock market is seemingly more familiar to the investor. Investing in bonds means buying the debt obligations of a company, state or local government, which it promises to repay at a certain time. The total global bond market is close to USD 130 trillion.¹ Bonds are in high demand at the moment due to generally higher yields, which is why Kaspars Šteinbergs, financial expert at Luminor bank, explains what is important for investors to know before buying them.

What affects bond yields? 

In the bond market, it is important to be familiar with two commonly used terms: yield and coupon. Coupon is the interest rate that the bond issuer commits to pay investors each year, calculated as a percentage of the nominal value of the bond. The yield, on the other hand, reflects the return a person earns by investing in a particular bond and holding it until maturity. Because bonds can be bought and sold on the secondary market, their price can fluctuate up and down, so the coupon payment an investor receives is not always the same as the return or yield.

Bond yields are influenced not only by the borrower’s financial data, but also by the decisions of national central banks. Over the last 10 years, bond investments have not been popular, with yields close to 0% or even negative. In 2022, central banks in the world’s major economies began to fight inflation by raising base rates sharply, pushing up bond yields. Investor interest in them naturally increased, especially among private investors. Whereas in previous years investors mainly invested in stock for profit, the bond market is now a very good alternative.

The yield also depends on the issuer’s credit rating (risk premium) and the maturity or time left to maturity of the bonds. 

What types of bonds are there?

There are several types of bonds, differing both in structure and the issuer. The most common are bonds that pay a fixed or constant interest rate. When one buys a bond, the bond issuer commits to pay a certain interest rate and, at maturity, to repay the amount borrowed—the nominal value of the bond. Interest can be paid at different times, usually quarterly, half-yearly or yearly. There are also bonds that do not pay interest, but are issued below their nominal value and the borrower pays the full nominal value at maturity, so the profit comes from the difference between the purchase and redemption price.

Bonds can also be classified according to their issuer: bonds issued by government, local government, and companies. In US dollars, US government bonds are used as the benchmark, while in Europe it is Germany. The probability that a company will not be able to service its commitments to the lenders or investors who bought the bonds affects the amount of the credit risk premium. The riskier the borrower, the higher the interest rate will have to be paid to borrow on the bond market. 

How are bonds bought?

Like buying stock, buying bonds requires a securities account with a bank and is not significantly different from buying other securities. The main difference is that a relatively large share of bonds are not available to individuals, but only to institutional or professional investors such as banks, pension funds, insurance companies. The minimum investment often starts at EUR 100,000. Of course, there are a fair number of bonds available on the market for private investors, and some of them are available with lower minimum amounts, even starting at EUR 100, but such issues are relatively fewer.

Bonds are more often chosen by clients with experience in financial markets, but over the past year, as bond yields have risen, they have also become more popular among new investors.

As with building a stock portfolio, buying bonds requires diversification. It is important to diversify bonds not only by issuer but also by maturity—the longer the maturity, the more volatile the price will be in the secondary market.

What does bond maturity mean?

The maturity date of a bond is the date on which the borrower repays the amount borrowed, or the nominal value of the bond. It is also possible to sell the bond before maturity, but in this case the bond will trade at its current market price, which may be higher or lower than the nominal value.

1 Capital Markets Fact Book, 2023 - SIFMA - Capital Markets Fact Book, 2023 - SIFMA