the not always intuitive behavior of bonds

Now is arguably a good time to lend money to a European company or state, with the ECB’s main policy rate at its highest level in more than 20 years. Nominal rate, yield, interest rate risk and sensitivity, here are the key elements to know before investing in bonds.

Differentiate nominal rate and rate of return

When we talk about “Lending money to France” to invest its savings, it’s a bit of a misnomer. When France, via the Agence France Trésor (AFT), launches a loan, it is only a selection of so-called “SVT” banks (specialists in Treasury value) which can respond to the auction. A portion of these securities is then available on the secondary market, the Stock Exchange, and that is where you can acquire French debt, particularly in the form of OATs (bond comparable to the Treasury) for periods of 2 to 50 years.

It may seem curious that French bonds are offered at interest rates as different as 0.50% or 3.50% (or even 6%). This nominal interest rate is only used to determine the amount of the coupon, that is to say interest paid in principle each year, based on the face value of the bond.

But it is not the real yield of the bond which will depend on your acquisition price. Thus, at the beginning of February, the price of the two OATs in the table above on the secondary market was 101.85% and 95.30% respectively. Indeed, bonds are quoted as a percentage of their nominal value. This rating evolves, not only according to supply and demand, but also according to the risk that the issuer represents for the markets.

Concerning the two OATs of French debt, their price on the secondary market represented annual returns of 2.63% and 2.64%.

It is this yield offered by the market that must be looked at as a priority when buying a bond, and not the coupon interest rate.

In life or direct insurance, are bonds the right plan at the moment?

Interest rate risk

When rates rise, bond prices fall. This point is essential to fully understand the behavior of bonds. And it’s not necessarily very intuitive.

For example, you have Italian government debt in your portfolio, with a bond with an annual coupon of 4.50% maturing October 2053. With state debt greater than that of France, it is not impossible that there will one day be tensions on the bond market and that Italy’s interest rates will soar.

You would think that since there is increased risk in the country and rates are rising, bondholders are winning. But no, quite the opposite is happening. If market yields increase from 4.35% (current situation for Italian debt) to 5.35%, the price of the bond will drop quite significantly here by around -15%. The price will then go from 102.40% of the nominal to 87.40% of the nominal. Conversely, an easing of rates would increase the valuation of the bond, since the new bonds would be less profitable than the old ones.

The sensitivity of the bond

We also talk about the sensitivity of the price to a rate fluctuation (or simply sensitivity of the bond).

“The notice of any bond fund must indicate its sensitivity. This index measures the impact of a 1% decrease (increase) in rates on the value of the fund,” explains the site. finance for all. A sensitivity of -5 means that the price of the bond falls by 5 points for an increase of 1 point in the yield.

In the previous example with Italian debt and a remaining maturity of 29 years, the sensitivity is particularly high, with a value of -15 since the price would go from 102.40% to 87.40% if the market yield went from 4.35% to 5.35%. This is a general rule: the greater the remaining time, the greater the sensitivity.

With this indicator, even if it remains approximate, you can easily know what to expect if the ECB drastically lowers key rates, and the yield on your bond finds itself halved!

Bond strategy and financial risk

With these behavioral basics, you can calmly invest in direct bonds, in a more selective manner than with a bond fund. You can therefore plan different investment strategies:

• Buy bonds for their yield by holding them until they are fully redeemed, regardless of the price movement.
• Buy bonds to resell them in a few months or years, when the ECB will have lowered key rates. You are then aiming for a capital gain and you will benefit from the accrued interest and coupons paid during the period.
• To balance a stock market portfolio by devoting a share to bonds.
• And why not in a timely manner during a state debt crisis, like Greece in 2016, by buying bonds cheaply, and reselling them once the difficulties have passed (at your own risk and perils).

Because, in addition to interest rate risk, investing in the debt of a State or a company presents several risk factors. The risk of defaultthat is to say the inability for the issuer to repay its debt, in the event of financial difficulties or bankruptcy. Liquidity risk, when there are complications or even an impossibility of reselling a bond on a sluggish market. And finally exchange rate riskwhen a bond is denominated in a currency other than the euro (or the currency of your income).

However, these risks are lower than investing in company shares. In the event of the company’s bankruptcy, bondholders are reimbursed in priority to shareholders. The volatility of a bond remains, moreover, lower than that of a stock.

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