Monthly Archives

November 2021

Bond Basics

We associate the term ‘bond’ with mutual connection, whether the subject is chemistry (between atoms, ions, or molecules), personal relationships (between human beings), or finance (between borrowers and lenders). The latter is often thought to be difficult to understand and shrouded in complex mathematics. Actually, bonds can be quite a straightforward concept.

In their simplest sense, bonds are IOUs set up between borrowers and lenders. At the outset, the borrower will determine how much and for how long they would like to borrow, and what they are willing to pay the lender – typically once or twice per year – as appropriate compensation for borrowing their money.

Bonds are also known as fixed income securities. The simple example of a bond setup below illustrates why bonds carry this other name. The future cash flows a lender receives are fixed and predictable. At the outset, a sum is lent. Each year, an amount is paid to the lender (the coupon) and at the end of the term the original sum is returned.

Figure 1: Simple illustration of a 3-year bond with an annual coupon

Borrowers, also known as bond issuers, are prominently composed of governments and companies around the world. A significant difference between bonds and more traditional loans is that bonds are marketable. In other words, the lender in the IOU agreement can sell the right to receive the cash flows to someone else. This is why the lender will more commonly be referred to as the bondholder.

The relationship between risk and return does not come unstuck for fixed income. If the borrower is a large, developed government it is highly likely that bondholders will be repaid and so the government can offer lower coupons. The USA, for example, has never defaulted on its national debt. By contrast, a company on the brink of financial collapse would have to offer much higher compensation to encourage lenders. This is the point where fixed income often becomes less ‘fixed’.

Analysing the ability for companies or governments to pay back lenders is a complex and comprehensive process for investors. Thankfully rating agencies do much of the heavy lifting. S&P, a rating agency, demonstrates[1] on average between 1981 and 2020 bonds with the lowest rating of CCC/C had a 28% chance of defaulting over the next 12-month period, whereas for those rated highest at AAA that chance was zero.

Figure 2: Cumulative average default rate % of global corporate bonds 1981-2020

Data source: S&P (2021). “Default, Transition, and Recovery: 2020 Annual Global Corporate Default and Rating Transition Study”. Rating refers to rating at outset of respective period.

The reader will notice that owners of investment grade bonds are considerably more likely to receive back the capital lent to the borrower compared with high yield bonds (formerly ‘junk’ bonds!). It is for this reason we allocate the fixed income element of your portfolio to these such bonds through the use of investment funds that diversify across many different highly rated bonds. We may often refer to this part of the portfolio as the ‘defensive assets’.

The key takeaways

  • A bond is an IOU between a borrower, such as a government or company, and a lender. The ownership of this IOU can be traded between lenders (bondholders), and with it the right to receive the cash flows from the borrower.
  • The main features of a bond are the maturity (i.e., term of the loan) and credit quality. The latter is determined by rating agencies and gives an insight into a borrower’s credit worthiness.
  • Investment grade bonds provide more certainty of future payments to lenders compared with high yield bonds. A shorter lending term also generally corresponds to higher certainty of repayment. For this reason, when investing in bonds we typically allocate to shorter term, higher credit quality securities.

If you have any questions, thoughts or actions relating to the content of this article please get in touch with us by calling us on 028 9099 6948 or by emailing

Risk warnings

This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy, or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed.

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

[1] S&P (2021). “Default, Transition, and Recovery: 2020 Annual Global Corporate Default and Rating Transition Study”

Employee Spotlight – Sean McCann

Each fortnight we will be spotlighting a member of the team so that you can get to know the people behind the Pacem brand. This week we feature one of our Planning analysts, Sean McCann. Sean joined the firm in 2021 from FinTrU, where he worked following university. He completed his Degree in Finance & Investment Management, achieving a First-Class Honours. Sean is undertaking Pacem’s Internship program currently and supporting our Financial Advisory team to assess and advise our clients on all their financial needs.

Sean tells us a bit more about himself below.

Employee name:
Sean McCann

Your role at Pacem:
Planning Analyst

How long have you been with Pacem?
7 months

What does your day-to-day role entail?
My day-to-day role is based around assisting in preparing reports and completing client work alongside our advisors. However, recently I have additionally been providing help with the compliance side of the business, this is an old acquaintance of mine as I previously worked in compliance.

How would you describe yourself in three words?
Diligent, ambitious, and motivated.

Tell us something that might surprise us about you.
I currently hold a golf handicap of 3, probably not a surprise to anyone in the office as its how I spend most of my evenings.

What do you like most about your job?
I enjoy the variety of the job; no two days are the same and you are continually learning and developing as a person.

If you won the lottery, what is the first thing you would do?
I dream of this most weekends but if I was to win it, I’d say I would probably share my wealth with my family and friends, no point in having that amount of money if you’re the only one enjoying it.

Favourite film
Nothing beats a great film; I would have to say my favourite film is Good Will Hunting.

Where is the best place you’ve travelled to and why?
New Zealand, I went out to see family and have to say the main reason I enjoyed it was it was similar to home but with better weather.