La duration of the bonds it can vary from a few months to 30, 50, 100 years or even be perpetual. For example, the Italian state issues Treasury Bonds (Boots) with maturities of 3, 6 and 12 months, the Multi-year Treasury Bonds with maturities from 2 to 50 years. The further away the maturity is, the longer the financial duration of the bond and the greater the price variation as the yield varies. Bonds are typically issued at a value of 100, with a coupon paid annually or semi-annually; at maturity the issuer will repay the value of 100. In this case the annual yield at maturity will coincide with the coupon.
Il price of a bond is equal to the present value of future coupons and the nominal value repaid at maturity. If the yield after issuance rises and the price of the bond falls, an investor who buys it after issuance will buy it at a lower price; the difference between the price paid and the value refunded at maturity will compensate for the fact that the coupon is lower than the yield. However, if the yield fell after the issue, the price of the bond would rise above par, i.e. above 100.
The choice of the duration of the securities to be purchased depends on the yield on the various maturities, on the expectations on the future trend of rates (and therefore on the expectations on the trend of the economies) and on the time horizon of the individual investor (let us first ignore the risk of credit). If we believe that yields are high, that the central bank is able to keep inflation under control, that the issuer remains solvent and if we have a long time horizon then it will be preferable to buy long-dated bonds in order to ensure an attractive return over a long period (or benefit from the price increase if yields actually fall).
At the time of writing this note, the Treasury - an American government bond - with a thirty-year maturity has a yield of around 4,5%, a level close to the highest levels of the last 15 years. If we believe that inflation returns close to the Fed's 2% target and that the United States remains solvent, securing a 4,5% yield for the next thirty years can certainly be interesting.
Fixed or variable rate
With reference to the coupon, the bonds can have fixed coupons (sometimes even increasing, step-up, like the BTP Futura and the BTP Valore - but defined at the time of issue) or variable, i.e. linked to a short-term market rate period. The Italian state issues Treasury Credit Certificates - CCTs - with a semi-annual coupon linked to the six-month Euribor plus a spread; the duration is between three and seven years. With a variable rate bond you do not run an interest rate risk as the coupon is adjusted to prevailing rates. Compared to a short-term bond such as the BOT, the CCT allows you to profit from a higher return due to the higher credit risk over a longer duration and the lower liquidity.
Inflation-indexed securities
Major countries issue inflation-linked government bonds. These bonds have a coupon - lower than a nominal bond with similar characteristics (issuer, maturity, issue date) - and provide for the periodic or maturity revaluation of the invested capital. This type of instrument therefore offers both a return, called real, which is a function of the coupon and the purchase price, and a protection of capital from inflation. The repaid capital increased based on the inflation accumulated in the reference period. The difference between the yield on a nominal bond and the yield on an indexed bond from the same issuer and with the same maturity indicates the break-even inflation rate, i.e. the market's expectations of the inflation rate in the period until the securities mature. The Italian state issues two types of indexed government bonds: the BTP linked to European inflation with maturities ranging from 5 to 30 years and the BTP Italia indexed to Italian inflation with a half-yearly revaluation of the capital and loyalty bonus at maturity.
The choice between nominal and inflation-indexed securities depends on one's inflation expectations compared to what is discounted by market prices. For example, immediately after the outbreak of the pandemic in March 2020, expected inflation, as derived from ten-year German government bonds, had collapsed to 0,2%. Investors were therefore particularly depressed and expected very low average inflation for the next ten years. At that stage, if it was believed that the situation would normalize, it was certainly better to buy bonds linked to inflation rather than nominal ones given that the real yield was very close to the nominal one. Reverse situation in the first half of 2022, when inflation expectations exploded due to the war in Ukraine and the consequences of the pandemic on supply chains. The 10-year breakeven inflation rate had jumped in May 2022 to 3%. Level that presupposed an inability on the part of the central bank to control inflation over a relatively long period of time.
Default risk
For corporate issues and those from countries with a low credit rating, considerations on the ability and willingness of the issuer to repay its bonds become at least as important as the interest rate risk linked to the maturity and type of coupon. An analysis of the issuing company's business, its sustainability, level of debt, ability to generate cash is absolutely essential.
Review
If the currency of issue is different from the investor's reference currency, for example the euro for us Italians, the risks linked to exchange rate fluctuations may be prevalent. It is true, for example, that at this stage US government bonds in dollars have a higher yield than equivalent German bonds in euros (at the time of writing this commentary the US 4,3-year Treasury has a yield of 2,4% compared to XNUMX% German), but a weakening of the dollar by even a few percentage points can easily more than nullify the yield differential.
Taxation
Finally, a comment on taxation. For individuals resident in Italy, income generated from government bonds (both Italian and from countries on the "white list", i.e. adhering to a series of agreements on the exchange of information) is taxed at 12,5%, a preferential rate compared to the 26% expected for bonds from other issuers. Therefore it is necessary to compare the returns net of the tax effect when comparing different types of securities.
