Bonds: The Predictable Part of the Portfolio

The most significant risk: The issuer could run into financial difficulties. In extreme cases, interest might not be paid, or the nominal value might not be returned in full upon the maturity date. The poorer the credit rating, the higher the risk – and therefore the higher the interest rate typically demanded by investors.

Rating agencies evaluate the creditworthiness of issuers using grades such as “AAA”, “BBB”, or “B”. Bonds with very good credit ratings are labelled “Investment Grade”. Bonds with lower ratings (High Yield or “Junk Bonds”) are enticing with high interest rates, but carry significantly greater risk of default. 

Bonds are sensitive to interest rate changes. If market interest rates rise, existing bonds with comparatively lower coupons become less attractive – and their price drops. On the other hand, if the interest rate falls, the price of existing bonds rises due to the higher coupon.

An example:

• You own a bond with a 2% coupon.

• The market rate for comparable new bonds rises to 4%. 

• Investors in the new issuances receive 4%. Your 2% bond thus becomes less attractive, which is reflected in a falling price – provided you wish to sell your bond on the stock market.

Long-term bonds are impacted especially hard: The longer the term remaining, the more sensitively the price will react to interest rate changes. 

The coupons and the repayment amount of a typical bond are fixed nominally. If inflation increases significantly, your interest income loses purchasing power in real terms. A bond with a 2% coupon appears attractive if the inflation rate is 1% – but if inflation is at 4%, the real return is negative, at minus 2%.

Not every bond is traded in high volumes on a daily basis. Especially with smaller issuers or very specialized structures, liquidity can be limited. Moreover, this can lead to larger spreads, i.e. the difference between the buy and sell price, making it difficult to exit quickly. 

If a bond is issued in a foreign currency, US dollars for example, exchange rate fluctuations can play an additional role: If the dollar falls versus the Swiss franc, you will receive less money when you convert it back.

Governments use bonds to finance their current expenses and investments. Bonds issued by economically and politically stable countries are generally regarded as comparatively safe, but their coupons are often moderate. Government bonds work as anchors of stability in many portfolios. However, even with government bonds, political decisions can send significant shockwaves through the markets. 

Companies issue bonds in order to finance investments, manage mergers, or to optimize their capital structure. These range in size from global corporations with high credit ratings to smaller or financially weaker companies. Corporate bonds usually offer higher coupons than government bonds – in exchange, investors have to accept a higher credit risk. 

High-yield bonds are offered by issuers with low credit ratings. The coupons are significantly higher in order to offset the increased default risk. Such bonds can be yield drivers within a portfolio, but they should only be used as a supplement and with full awareness of the risk.

In collateralized bonds, certain assets such as mortgage loans serve as collateral. This structure can offer additional protection, which is why the coupons are often somewhat lower than with comparable unsecured bonds from the same issuer.

With this type of bond, the coupon payment is not fixed, but instead adjusted regularly to a benchmark interest rate. If market rates increase, so do the coupons, and vice versa. Structures like this can help mitigate interest rate risks.

Sustainable bonds combine financing with climate, environmental, or social objectives by linking the bond conditions to measurable sustainability goals of the issuer.