focus on products U T t o d a y v o l u m e 7 2 0 0 9

Malaysia’s bond market is often characterised as being in a developmental phase. High

growth rates have been its hallmark, attributable to the increasing recognition of the
local bond market as a viable alternative for capital formation. Here’s everything you
need to know about bonds.

time discussing economic fore- as well as the benefits bonds can

By PIMCO, PIMCO Media Relations casts and how these forecasts may provide within an overall invest-

T
affect unique sectors of the bond ment strategy.
he bond market is by market, we have yet to answer  
far the largest secu- the most basic question:  What is What Makes a Bond a Bond?
rities market in the a bond?  First and foremost, a bond is a
world, providing inves- In this article, we will explain loan that the bond purchaser, or
tors with virtually lim- the fundamentals of the bond bondholder, makes to the bond
itless investment options. Many market, including pricing and issuer. Governments, corporations
investors are familiar with aspects interest rates, the risks of invest- and municipalities issue bonds
of the market, but as the number ing in bonds, and the traditional when they need capital. If you buy
of new products grow, even a bond role of bonds in an investment a government bond, you’re lending
expert is challenged to keep pace. portfolio. We will then explore the government money. If you buy
While we spend a great deal of the many sectors of the market, a corporate bond, you’re lending

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focus on PRODUCTS

ILLUSTRATION A

If interest rates rise

the corporation money. Like a assess the default risk of most
loan, a bond pays interest periodi- bond issuers and publish credit Yields
cally and repays the principal at a Rise
ratings in major financial newspa- Prices
stated time. pers. These ratings not only help Fall
  Suppose a corporation wants to investors evaluate risk but also
build a new manufacturing plant help determine the interest rates
for $1 million and decides to issue on individual bonds.  An issuer
a bond to help pay for the plant. with a high credit rating will pay a
If interest rates Fall
The corporation might decide to lower interest rate than one with
sell 1,000 bonds to investors for a low credit rating. Again, inves-
Prices
$1,000 each. In this case, the “face tors who purchase bonds with low Rise
value” of each bond is $1,000. The credit ratings can potentially earn Yields
Fall
corporation—now referred to as higher returns, but they must bear
the bond “issuer”—determines an the additional risk of default by
annual interest rate, known as the the bond issuer.
“coupon,” and a timeframe within  
which it will repay the principal, or What Determines the the opposite direction of its yield,
the $1 million. To set the coupon, Price of a Bond in the as shown in illustration A. The key
the issuer takes into account the Open Market? to understanding this critical fea-
prevailing interest-rate environ- Bonds can be traded in the open ture of the bond market is to rec-
ment to ensure that the coupon is market after they are issued. ognise that a bond’s price reflects
competitive with those on compa- When listed on the open market, a the value of the income that it pro-
rable bonds and attractive to inves- bond’s price and yield determines vides through its regular coupon
tors. Our hypothetical corporation its value. Obviously, a bond must interest payments. When prevail-
may decide to sell five-year bonds have a price at which it can be ing interest rates fall—notably
with an annual coupon of 5%. At bought and sold (see “Understand- rates on government bonds—older
the end of five years, the bond ing Bond Market Prices” below bonds of all types become more
reaches “maturity” and the corpo- for more). A bond’s yield is the valuable because they were sold
ration repays the $1,000 face value actual annual return an investor in a higher interest-rate environ-
to each bondholder. can expect if the bond is held to ment and therefore have higher
  How long it takes for a bond maturity. Yield is therefore based coupons. Investors holding older
to reach maturity can play an on the purchase price of the bond bonds can charge a “premium” to
important role in the amount of as well as the coupon.  sell them in the open market. On
risk as well as the potential return A bond’s price always moves in the other hand, if interest rates
an investor can expect. A $1 mil-
lion bond repaid in five years is
typically regarded as less risky
than the same bond repaid over
30 years because many factors
can have a negative impact on the
Understanding Bond Market Prices
In the market, bond prices are quoted as a percent of the bond’s face value. The
issuer’s ability to pay bondholders
easiest way to understand bond prices is to add a zero to the price quoted in the
over a 30-year period. The ad-
market. For example, if a bond is quoted at “99” in the market, the price is $990 for
ditional risk incurred by a longer
every $1000 of face value and the bond is said to be trading at a “discount”. If the
maturity bond has a direct relation bond is trading at “101”, it costs $1010 for every $1000 of face value and the bond
to the interest rate, or coupon, the is said to be trading at a “premium”. If the bond is trading is at 100, it costs $1000
issuer must pay on the bond. In for every $1000 of face value and is said to be trading at “par”. Another term you
other words, an issuer will pay a might hear is “par value”, which is simply another way of saying face value.
higher interest rate for a long-
term bond. An investor therefore
will potentially earn greater Face Value Price Quoted As Market Price The Bond is trading at
returns on longer-term bonds, but
$1,000 100 $1,000 “Par”
in exchange for that return, the
investor incurs additional risk.  $1,000 102 $1,020 A “premium” to par
  Every bond also carries some $1,000 97 $970 A “discount” to par
risk that the issuer will “default,”
$5,000 99 $4,950 A “discount” to par
or fail to fully repay the loan.
Independent credit rating services

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In the 1970s, the bond market began to  

evolve as investors learned there was Measuring Bond Risk: What
Is Duration?
money to be made by trading bonds in the Now that we have established that
open market. As investor interest in bonds bond prices and yields move in
grew, finance professionals created opposite directions, let us explore
the price-yield relationship in
innovative ways for borrowers to tap the more detail. How do we know how
bond market for funds and new ways for much a bond’s price will move
investors to tailor their exposure to risk when interest rates change? This
is a key question because some
and return potential.
bonds are more sensitive to chang-
es in interest rates than others.
  To estimate how much a specific
rise, older bonds may become less long-term investment picture: bond’s price will move when inter-
valuable because their coupons as a bondholder, you want to est rates change, the bond market
are relatively low, and older bonds earn the highest yields you can uses a measure known as “dura-
therefore trade at a “discount.” (within your given risk toler- tion.” Duration is a weighted aver-
Put simply, rising interest rates ance). Rising interest rates can age of the present value of a bond’s
are considered “bad” for bond actually boost a bond portfolio’s cash flows, which include a series
investors because new bonds will return over longer time periods, of regular coupon payments fol-
pay investors a higher interest rate as the money from maturing lowed by a much larger payment
than old ones, so old bonds tend bonds is reinvested in bonds at the end when the bond matures
to drop in price. Falling interest with higher yields. Conversely, and the face value is repaid, as
rates, however, mean that older falling interest rates, while help- shown in illustration B.
bonds are paying higher inter- ful to bondholders in the short As you can see from the illus-
est rates than new bonds, and term, mean that money from tration, duration is less than the
therefore older bonds tend to sell maturing bonds may need to be maturity. Duration will also be
at premiums in the market. reinvested in new bonds that pay affected by the size of the regular
  On a short-term basis, this is lower rates, potentially lowering coupon payments and the bond’s
true. However, keep in mind the longer-term returns.   face value. For a zero coupon

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bond, maturity and duration are investor faces the risk that the that consumers stop buying things
equal since there are no regular stock market will decline and take and prices in the economy begin
coupon payments and all cash the portfolio along for the ride. to fall—a dire economic condi-
flows occur at maturity. Because To offset this risk, investors have tion known as “deflation”—then
of this feature, zero coupon bonds long turned to the bond market bond income becomes even more
tend to provide the most price because the performance of stocks attractive because you can buy
movement for a given change in and bonds is often non-correlated: more goods and services (due to
interest rates, which can make zero market factors that are likely to their deflated prices) with the
coupon bonds attractive to inves- have a negative impact on the same bond income. As demand for
tors expecting a decline in rates. performance of stocks historically bonds increases, so do bond prices
  The end result of the duration have little to no impact on bonds and bondholder returns.
calculation, which is unique to and in some cases can actually  
each bond, is a risk measure that improve bond performance.  For Variations on a Theme:
allows us to compare bonds with example, an investor who pur- The Many Different Kinds
different maturities, coupons and chases a blue-chip stock and a of Bonds
face values on an apples-to-apples government bond may offset a Now that we’ve highlighted the
basis. Duration tells us the ap- downward market cycle in either main features common to virtu-
proximate change in price that any asset class because a drop in a ally all bonds, let’s move on to
given bond will experience in the particular company’s share price the bond market’s evolution and
event of a 100 “basis point” (one and a government’s ability to re- the many different types of bonds
percentage point) change in inter- pay a bond are usually unrelated. available in the global market. In
est rates. For example, suppose Although diversification does not its early days, the bond market
that interest rates fall by one per- ensure against loss, an investor was primarily a place for govern-
cent, causing yields on every bond can diversify a portfolio across ments and large companies to bor-
in the market to fall by the same different asset classes that
amount. In that event, the price perform independently in ILLUSTRATION B
of a bond with a duration of two market cycles to reduce
years will rise two percent and the the risk of low, or even

$
Coupon Repayments
price of a five-year duration bond negative, returns. Repayment
will rise five percent.   $$$$$$$$$$$$ of Face Value
  Protection Against
The Role of Bonds in Economic Slowdown or Duration
a Portfolio Deflation: Bonds can help
Investors have traditionally held protect investors against
bonds in their portfolio for three an economic slowdown
reasons: income, diversification, for several reasons. Recall that row money. The main investors in
and protection against economic the price of a bond depends on bonds were insurance companies,
weakness or deflation. Let us look how much investors value the pension funds and individual
at each of these in more detail. income that bonds provide. Most investors seeking a high quality
  bonds pay a fixed income that investment for money that would
Income: Most bonds provide the does not change. When the prices be needed for some specific fu-
investor with “fixed” income. On of goods and services are rising, ture purpose.
a set schedule, perhaps quarterly, an economic condition known as   In the 1970s, the bond mar-
twice a year or annually, the bond “inflation,” a bond’s fixed income ket began to evolve as investors
issuer sends the bondholder an becomes less attractive because learned there was money to be
interest payment—a check that that income buys fewer goods made by trading bonds in the
can be spent or reinvested in other and services. Inflation is usually open market. As investor interest
bonds. Stocks might also provide caused by faster economic growth, in bonds grew (and faster com-
income through dividend pay- which increases demand for goods puters made bond math easier),
ments, but dividends tend to be and services. On the other hand, finance professionals created
much smaller than bond coupon slower economic growth usually innovative ways for borrowers to
payments, and companies make leads to lower inflation, which tap the bond market for funds and
dividend payments at their discre- makes bond income more attrac- new ways for investors to tailor
tion, while bond issuers are obli- tive. An economic slowdown is their exposure to risk and return
gated to make coupon payments. also typically bad for corporate potential.
  profits and stock returns, add-   Broadly speaking, government
Diversification: Diversification ing to the attractiveness of bond bonds and corporate bonds remain
means not “putting all of your eggs income as a source of return. If the the largest sectors of the bond
in one basket.” A stock market slowdown becomes bad enough market, but there are a growing

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timely repayment of interest and can offer very attractive yields,

do not eliminate market risk. Also, they also pose special risks, in-
shares of a portfolio of govern- cluding but not limited to cur-
ment bonds are not guaranteed. rency fluctuation, economics,
  A number of governments also and political risk. An emerging
issue sovereign bonds that are market portfolio would usually
linked to inflation, also known be more volatile than that of a
as “linkers” in Europe or “TIPS” U.S.-only portfolio.
in the U.S. On an inflation-linked • Local Government Bonds
bond, the interest and/or princi- Local governments borrow to
pal is adjusted on a regular basis finance a variety of projects,
to reflect changes in the rate of from bridges to schools, as
inflation, thus providing a “real,” well as general operations. The
After the government sector, or inflation-adjusted, return. How-
ever, unlike other bonds, inflation
market for local government
bonds is well established in the
the next largest segment of the linked bonds could experience U.S., where these bonds are
greater losses when real interest known as “municipal bonds,”
bond market is corporate bonds, rates are rising faster than nomi- and European local government
accounting for nearly 30% of nal interest rates.
  In addition to sovereign bonds,
bond issuance has grown sig-
nificantly in recent years. In the
outstanding bonds in the global the government bond sector also U.S., municipal bonds (munis)
market, according to Merrill Lynch. includes a number of subcompo-
nents, such as:
may enjoy a tax advantage over
other bonds because interest
• Agency and “Quasi- on municipal bonds is exempt
Government” Bonds from federal taxes. However,
number of subcategories within Central governments pursue capital gains on U.S. munis are
these broad groups. There are various goals—supporting af- not tax exempt and income
also large segments of the market, fordable housing or the devel- from portfolios that invest in
such as mortgage-backed and opment of small businesses, munis may be subject to state
asset-backed securities, which do for example—through agen- and local taxes and, possibly,
not fall easily into either category. cies, a number of which issue the alternative minimum tax.
Here is what you need to know bonds to support their opera-
about the major sectors of the tions. Some agency bonds are Corporate Bonds
bond market: guaranteed by the central After the government sector,
  government while others are the next largest segment of the
Government Bonds not. For example, the German bond market is corporate bonds,
The government bond sector is a government guarantees bonds accounting for nearly 30% of out-
broad category that includes “sov- issued by the agency KfW, standing bonds in the global mar-
ereign” debt, which is issued and which makes housing and ket, according to Merrill Lynch.
backed by a central government. small businesses loans. Supra- Corporations borrow money in the
Government of Canada Bonds national organisations, like the bond market to expand operations
(GoCs), U.K. Gilts, U.S. Treasuries, World Bank and the European or fund new business ventures.
German Bunds, Japanese Govern- Investment Bank also borrow The corporate sector is evolving
ment Bonds (JGBs) and French in the bond market to finance rapidly and is one of the fastest
OATs are all examples of sover- public projects and/or devel- growing segments of the bond
eign government bonds. The U.S., opment. market, particularly in Europe.
Japan and Europe (primarily the • Emerging Market Bonds From the end of 2000 to the end of
U.K., Germany, France, Italy and Emerging market bonds are 2003, the outstanding amount of
Spain) dominate the government sovereign bonds issued by bonds issued by non-financial euro
bond market, accounting for more countries with developing area corporations grew nearly
than 84% of all government bonds economies, including most of 60%, according to the European
outstanding.2 Sovereign bonds is- Africa, Eastern Europe, Latin Central Bank.
sued by these major industrialised America, Russia, the Mid-   Corporate bonds fall into two
countries are generally considered dle East and Asia excluding broad categories: investment-
to have very low default risk and Japan. The emerging market grade and speculative-grade (also
are among the safest investments sector has grown and matured known as high-yield or “junk”)
available. However, we should significantly in recent years, bonds. Speculative-grade bonds
note that guarantees on govern- attracting many new investors. are issued by companies perceived
ment bonds tend to relate to the While emerging market bonds to have a lower level of credit

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The government bond sector is a broad category that includes “sovereign” debt, which
is issued and backed by a central government. Government of Canada Bonds (GoCs), U.K.
Gilts, U.S. Treasuries, German Bunds, Japanese Government Bonds (JGBs) and French OATs
are all examples of sovereign government bonds.
quality and higher default risk
compared to more highly rated,
investment-grade, companies.
Within these two broad catego-
ries, corporate bonds have a wide
range of ratings, reflecting the fact
that the financial health of issuers
can vary significantly (see table).
  Speculative-grade bonds tend
to be issued by newer companies,
companies that are in a particularly
competitive or volatile sector, or
companies with troubling funda-
mentals. While a speculative-grade
credit rating indicates a higher
default probability, higher coupons
on these bonds often compensate
for the higher risk. Ratings can be
downgraded if the credit quality of
the issuer deteriorates or upgraded
if fundamentals improve. An example of Government Bonds – USD$1000 Savings Bonds.
  In recent years, new securi-
ties have emerged that provide management risk and the risk that residential homeowners.
investors with additional options a portfolio could not close out a Mortgage lenders sell
for gaining exposure to corporate position when it would be most individual mortgage loans to
credit. For example, investors can advantageous to do so. another entity that bundles
buy credit default swaps that pro-   those loans into a security that
vide insurance against a default by Mortgage-Backed and pays an interest rate similar to
the corporate bond issuer. Credit Asset-Backed Securities the mortgage rate being paid
default swaps can also be used to Another major growth area in by the homeowners. As with
gain exposure to corporate credit the global bond market comes other bonds, mortgage-backed
without buying actual corporate from a process known as “se- securities may be sensitive to
bonds, or to “sell short” corpo- curitisation,” in which the cash changes in prevailing interest
rate exposure, which was previ- flows from various types of rates and could decline in
ously not possible. Credit default loans (mortgage payments, car value when interest rates rise.
swaps and other corporate credit payments or credit card pay- And while most mortgage-
derivatives have also been bundled ments, for example) are bundled backed securities are backed
into index products that allow for together and resold to investors by a private guarantor, there is
diversified, and in some cases lev- as securities. Mortgage-backed no assurance that the private
eraged, exposure to a broad array securities and asset-backed se- guarantors or insurers will
of corporate credit. curities are the largest examples meet their obligations.
  Derivatives carry their own of securitisation, but there are • Asset-Backed Securities
distinct risks and portfolios invest- many other variations. Here is These bonds are securities
ing in derivatives could poten- what you need to know about the created from car payments,
tially lose more than the principal major types of securitised loans: credit card payments or
amount invested. Derivatives may • Mortgage-Backed Securities other loans. As with mortgage-
involve certain costs and risks These bonds are securities backed securities, similar
such as liquidity risk, interest created from the monthly loans are bundled together
rate risk, market risk, credit risk, mortgage payments of many and packaged as a security

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that is then sold to investors. Now that you are familiar with manager might sell shorter-term
Special entities are created the major types of bonds—and bonds and buy longer-term bonds.
to administer asset-backed recognise that there are many On the other hand, a bond man-
securities, allowing credit variations within each of the ager expecting interest rates to
card companies and other major categories we have dis- rise would normally shorten the
lenders to move loans off of cussed—let us move on to some bond portfolio’s duration by buy-
their balance sheet. Asset- of the major bond investment ing shorter-term bonds and selling
backed securities are usually strategies investors or their bond longer-term bonds. In the event of
“tranched,” meaning that loans managers employ. rising interest rates, the price of a
are bundled together into   shorter-duration portfolio should
high-quality and lower-quality Bond Investment Strategies fall less than that of a longer-dura-
classes of securities. Similar Investors have several options for tion portfolio. 
to mortgage-backed securi- adding bonds to their portfolio. Another active bond invest-
ties, asset-backed securities One option is to invest with an ment strategy is to adjust the
contain similar rights, as dis- “active” bond manager that will credit quality of the portfolio.
cussed above. employ various strategies in an For example, when economic
• Pfandbriefe and effort to maximise the return on growth is accelerating, an active
Covered Bonds a bond portfolio and outperform manager might add bonds with
German securities secured the market’s return as meas- lower credit quality in hopes that
by mortgages are known as ured by a selected benchmark. the bond issuers will experience
Pfandbriefe or, depending A second option is to invest credit improvement with the
on the size of the offering, with a “passive” manager whose positive change in the economy
“Jumbo” Pfandbriefe. The goal is to replicate (rather than and the bond prices will rise. In
Jumbo Pfandbrief market is outperform) the returns of the some cases, active managers take
one of the largest sectors of bond market or a specific sector advantage of strong credit analysis
the European bond market. of the bond market. A third op- capabilities to identify sectors of
The key difference between tion is to invest in a “laddered” the market that seem likely to im-
Pfandbriefe and mortgage- bond strategy, in which maturing prove, therein potentially increas-
backed or asset-backed securi- bonds are passively reinvested in ing a portfolio’s return.
ties is that banks that make new bonds without any attempt A third active bond strategy is
loans and package them into to maximise returns. to adjust the maturity structure
Pfandbriefe keep those loans Investors have long debated of the portfolio based on ex-
on their books. Because of the merits of active management pected changes in the relationship
this feature, Pfandbriefe are versus passive management and between bonds with different ma-
sometimes classified as corpo- laddered strategies. The key con- turities, a relationship illustrated
rate bonds. However, unlike tention in this debate is whether by the “yield curve.” While yields
mortgage and asset-backed the bond market is too efficient to normally rise with maturity, this
securities, Pfandbriefe are allow active managers to con- relationship can change, creat-
backed by all the loans of the sistently outperform the market ing opportunities for active bond
issuing bank. Other nations in itself. An active bond manager, managers to position a portfolio
Europe are increasingly issu- such as PIMCO, would counter in the area of the yield curve that
ing Pfandbrief-like securities this argument by noting that both is likely to perform the best in a
known as covered bonds. size and flexibility enable active given economic environment.
managers to optimise short- and  
The non-government bonds long-term trends in order to out- Conclusion: Bonds are the
described above tend to be priced perform the market. Cornerstone of a Well
relative to a rate with little or Active bond managers com- Diversified Portfolio
no risk, rates such as govern- monly adjust a bond portfolio’s Bonds offer investors fixed-in-
ment bond yields or the London duration (the weighted average come payments, portfolio diver-
Interbank Offered Rate (LIBOR). duration of all the bonds in the sification and a hedge against
The difference between the yield portfolio) based on an economic an economic slowdown.  As the
on a lower-rated bond and the forecast. For example, in anticipa- largest securities market available,
government or LIBOR rate is tion of declining interest rates an bonds offer a plethora of choices
known as the “credit spread.” active manager may lengthen a for investors seeking price protec-
Credit spreads adjust based on portfolio’s duration because the tion. The unique characteristics of
investor perceptions of credit longer the duration, the more the many bond issuers in today’s
quality and economic growth, as price appreciation the portfolio market create opportunities for
well as investor demand for risk will experience if rates decline. investors with a broad spectrum of
and higher returns. To lengthen duration, the bond risk/return objectives.

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