Whether investing in a single bond or a portfolio of bonds, aside from default risk, the following factors also influence bond returns:
1. Average Yield to Maturity
The yield to maturity (YTM) is based on the purchase price, interest, and the term of the principal that the annualized rate of return calculated for a bond purchase, assuming no default. The higher the YTM, the higher the long-term return for the investor.
2. Average Maturity and Duration
The terms 'Maturity' and 'Duration' of a bond are often confused.
Bonds with longer maturity periods generally offer higher returns due to higher uncertainty in repayment. However, maturity doesn't assess the impact of interest rate changes.
Duration is an indicator used to measure a bond to interest rate changes. Simply put, it assesses how sensitive a bond is to interest rate fluctuations while being held.
3. Interest Rate Risk
Interest rates and bond prices are inversely related: when interest rates fall, bond prices rise, and vice versa.
This is not a 100% correlation but is generally the case.
For example, if you buy a bond for 1,000,000 USD at a 1% interest rate, maturing in a year, you would expect to receive 10,000 USD in interest plus the principal of 1,000,000 USD, totaling 1,010,000 USD.
However, if market interest rates suddenly rise to 3%, new bonds will receive 30,000 USD in interest plus the principal 1,000,000 USD would total 1,030,000 USD.
Suddenly, the bond you hold becomes less attractive because the amount due at maturity is fixed. The price of the bond you hold needs to be reduced to 970,800 USD (selling price of the bond = 1,000,000 / (1 + 3%) = 970,800 USD) to align with the current market interest rate of 3% and attract investors to take over your bond.
Note: The difference between Individual Bonds , bond funds and bond ETFs:
Individual Bonds:
Mainly about regular interest payments and receiving the bond's face value at redemption. While bond prices are affected by interest rates, as long as you don’t sell, the market price fluctuations are irrelevant to your returns. In the absence of default, you can steadily collect the YTM (return rate) set at purchase, which remains unchanged.
However, not selling doesn’t mean there's no profit or loss. There's still an opportunity cost with profit and loss, and the received interest still needs reinvestment, which will be affected by current interest rates, though not directly reflected in the original position.
Bond Funds or Bond ETFs:
As portfolio bonds is constantly adjusted through buying and selling, involving the continuous selling of some bonds and the purchasing of new ones, it is also affected by interest rates. Therefore, the trend of bond funds and bond ETFs generally inversely correlates with interest rate changes.
4. Market Sentiment Risk
When the market senses a crisis, funds flow from the stock market to the bond market, pushing bond prices up and lowering the yield. Conversely, when the stock market is booming, funds flow from the bond market to the stock market, leading to a fall in bond prices and a rise in yield.