What investors should look out for in coupons?
Turbulent times for bonds
The coupon is back! And bond investors are returning in rows. But the current situation with rising coupons after several years of extremely low coupons has its pitfalls. Volker Schmidt explains what investors should watch out for.
Euro bonds with a quality rating - for example German government bonds - have a coupon of 2% again. German covered bonds (Pfandbriefe) and bonds of very well rated companies fetch 3%. BBB-rated companies even offer 4% and more. "One could also say that ‘the investor's joy is the debtor's sorrow’," comments Volker Schmidt, Senior Portfolio Manager at ETHENEA Independent Investors S.A. "Just a few years ago, it was the other way around: good times for debtors and bad for investors, with excesses of negative yields.”
Now, many investors who have left the market in times of negative yields want to get back in. "Newly issued bonds will again have a notable coupon - after the turn of the times in 2022, the return of inflation and the desperate countermeasures of the central banks in the form of record interest rate hikes in a very short time," explains the ETHENEA expert. "But can all debtors bear the higher burden? And what about the bonds that trade well below 100% but carry only a mini-coupon - are they all at risk of default?"
The bond price does not allow a reliable conclusion of the issuer´s creditworthiness
The hot phase of interest rate hikes was ushered in at the latest with the first interest rate hike by the US central bank in March 2022 - at that time, US inflation was already more than 7%. From then on, central bank interest rates rose at a record pace in 2022. This also completely eliminated the mountain of negative-yielding bonds, which had stood at 8 trillion US dollars at the beginning of 2022 and 18 trillion US dollars at its peak in 2021.
"The rate hikes were also reflected in record bond price losses in 2022. The broad Bloomberg Euro Aggregate Index, which tracks all investment-grade bonds denominated in euros, lost more than 17% in 2022. The average yield of all bonds included in the index rose from 0.2% to 3.42% in the same period," Schmidt explains. "But this also means that many bonds issued in 2021 are now trading at prices well below 100%." He cites the example of the German government bond maturing in August 2031 with a coupon of 0%, which was trading at just under 80% at the end of 2022. "This bond obviously has the same probability of default as any other bond from the same issuer, and recently issued bonds with a reasonable coupon are trading at 100%. Therefore, the price of a bond is not a clear signal of its creditworthiness," the senior portfolio manager elaborates. "Of course, however, a price significantly below 100% can indicate a declining credit rating: Wirecard's bond is an example of this."
Explanatory example: Are coupons the solution?
Basically, the best ratio for calculating the expected return on a bond is the yield. This calculates the expected annual return on a bond investment and thus reflects the future coupon income as well as the price gains or losses from the current market price to the redemption price of 100%. "An investment in a bond with a high or a low coupon is therefore equally promising as long as they have the same yield, the same remaining term to maturity and the same credit risk," Schmidt explains.
However, the situation is somewhat different when the default risk of the bond is taken into account. This is illustrated by looking at two fictitious bonds of the same issuer with a remaining term of two years: One bond is traded at 90% and pays no coupon, the other bond is traded at 100% and pays a coupon of 5%. The bonds therefore each have a yield of approximately 5%. If the investor invests EUR 1,000 in both bonds and both bonds default shortly before maturity, then he has already received one interest payment (annual coupon) or even three interest payments (semi-annual coupon) for the bond with a coupon, but no payment yet for the bond without a coupon. So, the more coupons have already been paid, the better for the bond investor. On the other hand, when buying the bond without a coupon, he has a higher nominal claim, since with the EUR 1,000 and a price of 90% he has acquired bonds with a nominal value of around EUR 1,111. The higher the nominal claim, the more it is worth, the higher the redemption rate.
"So high coupons are not necessarily better than bonds with low coupons but low prices. For the investor it should be irrelevant whether his return consists of coupons or price gains," sums up ETHENEA expert Volker Schmidt. "Currently, the yield levels of over 3% that have already been reached offer a certain degree of protection, but in principle, further price losses cannot be ruled out in anticipation of rising central bank interest rates in the future. It is reassuring that there are coupons to be earned again, knowing that coupons are not the only solution."
