Investing Basics
Lending money to an institution behaves nothing like owning part of one
A bond is a loan with a schedule attached, and because its payments are fixed in advance its price moves for reasons that have very little to do with company performance.
By Pranav Kulkarni4 min read
A share is ownership and a bond is a loan
The two things most household portfolios contain are structurally opposite. Owning part of a company means holding a claim on whatever it earns after everyone else has been paid, with no promise attached and no end date. Lending to a company or a government means holding a promise of specified payments on specified dates, and nothing beyond them.
That difference cascades into everything else. An owner has unlimited upside and stands last in the queue if things go badly. A lender has capped upside — the payments are the payments — and stands ahead of the owners if the borrower fails.
So the questions worth asking of each are different. Of ownership: how much might this business earn in the future? Of lending: will the promised payments actually be made, and what else could that money have earned in the meantime?
Households usually meet both inside pooled arrangements rather than individually, which blurs the distinction further, because the two arrive in similar-looking wrappers and are described in the same language. The underlying claims are still entirely different things.
A fixed promise plus a changing world equals a moving price
The central mechanism of a bond is easy to state and easy to forget. The payments are fixed at the outset, so if the return available on newly issued lending rises, the older promise becomes less attractive by comparison, and the only way to make it competitive is for its price to fall.
The same works in reverse. If newly available returns fall, an older promise paying more becomes desirable, and its price rises accordingly. Price and prevailing return move opposite ways, and nothing about the borrower needs to change for it to happen.
This surprises people who assumed lending was the safe half of a portfolio. It is safer in one specific sense — the payments are contractual rather than discretionary — and it is not immune to the value of the holding moving about while those payments continue arriving exactly as promised.
Two different worries, often confused
Lending carries two broad risks and they behave differently. One is that the borrower does not pay, which is a matter of the borrower’s finances and is generally higher for weaker borrowers and lower for stronger ones. The other is the price sensitivity just described, which is a matter of how long the promise runs for.
The second risk grows with time remaining. A promise due to be repaid shortly cannot move very far in price, because the repayment is close and known. A promise running for decades has far more room to move, because a change in prevailing returns applies to many years of fixed payments.
A household holding lending for its steadiness may therefore be holding something quite volatile without realising it, if the promises involved run for a long time. Conversely, someone worried about price movement can reduce it substantially by holding shorter promises, at the cost of the return normally attached to lending for longer.
Illustrating why the price has to move
Take an illustration and treat it strictly as one. Suppose a promise pays 50 a year and was issued at a price of 1,000, so it returns 5% at that price. Now suppose newly issued equivalents are being offered at 6%. Nobody will pay 1,000 for 50 a year when 60 a year is available for the same money.
The old promise therefore trades below 1,000, and it falls to roughly the point where 50 a year represents a competitive return on the reduced price. The payments never changed. The alternative changed, and the price adjusted to reflect it.
The figures here are chosen for arithmetic rather than realism, and actual pricing involves the timing of every payment and the eventual repayment as well. The mechanism, though, is exactly this, and it explains most of what a lending holding does from day to day.
Where lending sits in a household’s thinking
The traditional role of lending in a mixture is to behave differently from ownership, which reduces how much the whole moves together. That is a reasonable description of the intention and a less reliable description of every period, since there have been stretches where both fell at once.
It is also worth remembering that lending has an inflation problem built into it. A fixed payment is fixed in name, and what it buys declines as prices rise, which is precisely the risk that ownership is better equipped to handle over long periods.
What proportion of anything a household should hold is not a question a general article can answer, and it depends on the horizon, the purpose and how much movement the household can tolerate without acting. That is a conversation for a regulated adviser, who can look at the whole position rather than one instrument in isolation.
Common questions
Why does the value of a bond holding fall when returns rise?
Because its payments were fixed when it was issued. If newer lending offers more, the older promise can only compete by costing less, so its price falls until the fixed payments represent a comparable return on the lower price.
Are bonds safer than shares?
They rank ahead of ownership if a borrower fails, and their payments are contractual rather than discretionary, so in that specific sense yes. But their prices still move, long-dated promises can move a great deal, and their fixed payments lose purchasing power as prices rise.
What does the length of a bond change?
Mostly how sensitive its price is to changes in prevailing returns. A promise repaid soon has little room to move; one running for decades applies any change to many years of fixed payments and moves correspondingly more.
Pranav joined to cover spending, saving, debt and stayed for the awkward questions and is happiest when a piece answers the question completely.
