Bonds are a notoriously hard asset class to understand when you scratch beneath the surface. It doesn’t help that the bond world speaks in its own unfamiliar language – one festooned with special bond terms that are hard to learn if you’re an outsider.
Our remedy is this quick guide to the main bond jargon you need to know. We’ll add more over time, to make this jargon buster a companion to our bond articles.
Bond terms to know
Bond market interest rates
‘Interest rates’ in the context of bonds does not refer to the central bank interest rates we’re used to. Instead, we’re talking about the rates that prevail within the bond market.
Each and every bond is subject to a ‘market’ interest rate – which is the return investors demand for locking up their money in that particular bond at that time.
Investors express their demand through their decisions to buy and sell.
Market rates fluctuate in-line with economic data. Changes to inflation expectations, a bond’s credit rating, its maturity date, and yes, central bank interest rates – all this and more feeds into market interest rates.
Principal
A bond’s principal is the original value of the loan made to the bond issuer. When the bond matures, the principal is paid back to whoever owns the bond on that date.
Principal is also called par value, nominal value, or face value. The standard face value of a UK gilt is £100.
Coupon rate
The fixed interest rate paid by a bond. For example, a bond with a 4% coupon pays £4 per year on its principal of £100.
Maturity date
The day the bond debt is finally cleared. On that day the issuer pays the bondholder the face value of the bond. The parcel of debt it represents is cancelled out – the bond is redeemed.
Yield-to-maturity
Yield-to-maturity (YTM) is a bond’s expected annualised return if you hold it to maturity (ignoring costs). This yield takes into account the bond’s current price, and assumes all remaining coupon payments are reinvested at the same yield.
An individual bond’s yield-to-maturity continually adjusts to reflect market interest rates as investors trade.
The mechanism is:
When a bond’s market interest rate rises, its price falls. (Investors require a greater incentive to hold this bond – hence prices drop.)
When a bond’s market interest rate falls, its price rises. (Investors are more willing to hold this bond – hence they’ll pay more.)
When a bond’s price falls, its yield-to-maturity rises. (The price fall causes the yield to increase to match the higher market interest rate).
When a bond’s price rises, its yield-to-maturity falls. (The price rise causes the yield to decrease to match the lower market interest rate).
YTM is the go-to metric to use when comparing similar bonds (for example gilts) that vary by price, maturity date, and coupon.
There are many types of bond yield. But we’re usually talking about YTM when we use the term ‘yield’ in an article on Monevator.
Nominal / conventional bond
The standard type of bond that pays back a fixed coupon rate and a fixed face value. Nominal bonds contrast with index-linked bonds that make payments in line with inflation. Index-linked bonds are also called inflation-linked bonds, or ‘linkers’ if they’re gilts and TIPS if they’re the U.S. equivalent.
High-grade bond
A bond with a credit rating of AA- and above (or Aa3 in Moody’s system). Typically the highest-quality bonds are government bonds.
Credit rating
This is a guesstimate of the financial strength of the bond issuer. That means for example the UK and other governments for government bonds, or the issuing company for corporate bonds.
AAA is the top-notch rating. BBB- sets the floor for investment grade. Below that is termed ‘high-yield’ or less flatteringly ‘junk’.
The higher the credit quality rating, the better. It means there’s less chance the issuer will default on payments, according to the bond rating agencies.
Of course you’ll usually have to accept a lower yield for a (less risky) higher credit rating.
Modified duration is an approximate guide to how much a bond will gain or lose in response to a 1% change in its yield.
For example, if a bond or bond fund’s duration number is 8, then it:
Loses approximately 8% of its market value for every 1% rise in its yield
Gains approximately 8% for every 1% fall in its yield
Macaulay duration is the average time (in years) it takes to receive all of your bond’s cash flows (coupons and principal). It also tells you how long it takes to recoup a bond’s price.
Macaulay duration in particular is a complicated concept for non-financial wonks to wrap their heads around. But happily, you don’t really need to.
Duration as used to describe interest rate sensitivity is the more important of the bond terms here for everyday investors because it provides insight into how wildly your bond or fund’s price may change as rates fluctuate.
Macaulay duration becomes relevant if you practice duration matching – which we’ll cover in an upcoming two-parter.
Interest rate risk
Here the risk is that an adverse move in bond interest rates causes losses. This risk decomposes into two elements:
Price risk
Reinvestment risk
Price risk
Price risk materialises when bond interest rates rise and cause your bond’s price to drop, inflicting a capital loss.
Reinvestment risk
When market interest rates fall, bond yields fall. Reinvested cashflows now earn a lower yield which erodes your annualised return over time.
Other bond terms that confound YOU
Time for a bit of crowdsourcing! We know that many readers are confused by bonds, so is there any particular jargon you’d like to see included in this guide?
Let us know in the comments below and we’ll add it to the guide.
Thanks for reading! Monevator is a spiffing blog about making, saving, and investing money. Please do sign-up to get our latest posts by email for free. Find us on Twitter and Facebook. Or peruse a few of our best articles.
A friend of mine was bemoaning how some of his staff were not enthusiastic about his upcoming office Christmas party.
Covid cancelled the previous two. My extrovert friend is beside himself to get back to the minefield of Secret Santa, the lottery of dinner seating, and drunken karaoke with two bemused blokes from the Reading office.
I suggested that if somebody didn’t want to join the party, he just gave them £100 in lieu to do whatever else they liked instead.
Which went down like the mini Bounties in a box of Celebrations.
Of course my friend protested that this was a bonding event. Which was what justified the £10,000 budget. An investment in team morale. A chance for colleagues who’d never met to get to know each other.
Indeed anyone who would actually take the £100 alternative would only be revealing themselves as being outside of the team.
The opposite of what he was trying to achieve!
Brent crude
Look, I see both sides. And I’ve been to some excellent office parties featuring genuine friends. Albeit usually as a contractor who rarely saw an 8.45am start with the gang – as opposed to being a wage slave forced to spend another six hours of my life with Gary from accounts, when all that keeps me sane is the 40-hour cap on Gary in a normal working week.
I don’t believe anyone should be put through the cruel and unusual punishment of an office party if that’s how they’ll find the forced festivities.
Besides, wouldn’t my suggested £100 Get Out Of Jail bonus equally inspire warm feelings from somebody dreading the alternative?
I believe so, but I didn’t win over my friend.
And so somewhere in London in the next two weeks you might run into yet another 50 incongruous diners in variously coloured paper hats talking about the prospects for an upcoming trade show – only to be interrupted by my friend standing up to deliver his surely-hilarious end of year awards.
He can’t say he wasn’t warned.
But what do you guys think? Am I being a Mr Scrooge? Or has the pandemic put the clad-iron case for certain office rituals to the sword forever? Share you worst – or who knows, maybe your best – Christmas party anecdotes in the comments below.
However you did it, now you’ve got it. (Or you wish you did and you’re daydreaming…)
The question is how much interest do you earn on your million pounds?
Well, it depends. Let’s see.
How much interest will I earn on one million pounds in cash?
First things first: stop looking for the single best savings account for your million pounds.
Anyone who remembers the bank runs of 2007 during the financial crisis knows it’s better to have multiple savings accounts. Each account should ideally have no more than the guaranteed £85,000 compensation scheme limit in the UK.
Admittedly that’s going to mean you’ll need almost a dozen bank accounts to be entirely safe. Besides the hassle of opening so many accounts, you’ll have to accept it’s impossible to get the best interest rate with all of them.
And that’s important, because the interest rate is the most important variable that determines how much you will earn on your million pounds.
The key factors are:
The interest rate
How long you save it for without withdrawing any money
Whether you’re paid interest daily, monthly, or annually
1. What is the interest rate?
The higher the interest rate, the more your £1,000,000 will earn you in a year.
A 4% interest rate paid annually will earn you £40,742
A 6% interest rate paid annually will earn you £61,678
Over one year, this maths is not surprising. Keep your million quid safe and untouched for 30 years though, and even a small 2% difference will have huge consequences. More on that below.
2. How long will you wait before withdrawing any money?
The longer you leave your million pounds untouched, the more money you’ll earn at the end. This is due to compound interest, which really gets going over long time periods.
Compound interest means you earn interest on your interest
The longer you leave your money untouched, the more the interest rolls up and grows. You get interest on the original interest, and then interest on the interest ON the original interest. And so on!
We’ll see the difference it makes in a moment.
3. How often is the interest worked out and paid?
The interest due on your headline annual savings interest rate – 4% for example – can be calculated and paid by your bank on a daily, monthly, or annual basis.
Having smaller amounts of interest paid more regularly is better than getting a once-a-year lump sum. That’s because the interest you earn has more time to earn interest on itself when you get it sooner.
I’ll assume for this piece that your interest compounds monthly. This is the most common approach in my experience.
So, how much interest do you earn on a million pounds?
First, let’s assume an interest rate of 4%, compounded monthly.
Held for the following time periods, a million pounds will earn you:
Remember we are looking at how much you earn on a million pounds here. Just the interest, and then the interest on the interest.
If you want to see how much you will end up with in your savings pot – including your initial million pounds – try our compound interest calculator.
Lessons for millionaire readers (and the rest of us)
Calculating how much interest you earn on a million pounds over the long-term – and at different interest rates – demonstrates two crucial things:
A small difference in the interest rate makes a big difference
Compound interest can grow your money by a huge amount over time
To illustrate the first point, look at the amount earned after 20 years in both examples above.
The 6% account has earned almost twice as much as the 4% paying account. That’s a huge difference from a seemingly tiny 2% rate gap.
As for my point about time, just look at the amount of money you’d have earned after 30 years at 6% interest.
Over £5 million!
Remember, you’d have your original £1 million, too. That means you’d have more than £6 million to your name after 30 years.
Higher interest rates for cash savers
Some good news here is that savings accounts are finally paying good interest rates again. Earning a 4% interest rate may soon be realistic, though it’ll probably be a while before we can earn 6% on our cash savings.
Note that if you’ve got a lot of cash, you may want to stash it in a cash ISA.
That’s because you’ll earn much more interest on a million pounds – or even on £100,000 – than is covered by the personal savings allowance. And you’ll be taxed on this income outside of an ISA.
Compound interest makes it possible
I remember the first time I encountered compound interest. It was in an article exactly like this one I’m writing, except I was reading it in an old-fashioned magazine instead of on a computer screen.
I almost dropped the magazine in shock.
The ability of money to roll up like this still seems to me a massive incentive to start saving and investing. It’s almost like getting free money.
One last example.
Let’s say you’re a 20-year old singer who records one hit single, tops the charts, makes a million, and then sticks your money in the bank at 6%.
If we assume you resist the temptation to spend your stash on wine, women (or men), and song, you could retire at 65 with nearly £14,000,000!
The bottom line: Working out how much you will earn on a million is a very nice problem to have.
P.S. Can you live off one million pounds?
What if you tried to live off the annual earnings of a million rather than letting it build up?
Things would be rather bleaker. The most you’d ever earn is the annual interest – so £40,000 a year from a 4% interest rate.
Nice, but it’s hardly going to pay for a millionaire lifestyle. And your million would never get compounded because you’d always be spending the interest.
As I’ve mentioned, you’d also have to pay tax on your interest. Tax rates vary around the world, but in the UK you’d pay between 20% and 40% tax on most of that income.
Worse, inflation will reduce the buying power of your £1,000,000.
Inflation tends to run at about 2-3% a year, although the high inflation of 2022 topped 11%. High inflation quickly makes both your million and the earnings on it worth less in real terms over time.
You’d still be earning £40,000 in 20 years on your million pounds, but it would buy far less stuff in practice. That would mean you’d be able to afford far fewer bottles of wine or holidays abroad.
Should you keep a million in cash or invest it?
Inflation is the main reason why living off the interest on a million pounds is not very realistic, unless you’re very old.
You’ll probably be better off in the long run if you invest your million pounds into a portfolio of income-producing assets.
Think cash, bonds, dividend paying shares, and property you rent out.
From moment you diversify into ‘real assets’ like shares and property your net worth will fluctuate. That can be painful in a down market for your assets. But your investment income will hopefully keep up with inflation over the long-term.
There can also be tax benefits with these alternatives to earning interest on a million pounds in cash.
You may need personal financial advice when that day comes – a million pounds is still a lot of money – but there’s no harm in dreaming in advance!
If you are a druid, perhaps you were recognizing the Autumn Equinox? K-pop superstars Blackpink were celebrating their first UK number one.
For my part I was trying to divine the thinking behind Liz Truss and Kwasi Kwarteng’s freshly-delivered fiscal plans.
Mini Budget Day! Only a couple of months ago, but already it feels like a fevered dream. Indeed when I reread my report on what I then called the ‘Push-Me-Pull-You’ budget, I see I illustrated it with a strange two-headed beast.
That image appears only more appropriate with hindsight. Because the Mini Budget put UK capital markets into Nightmare Mode.
Investors took fright as the cavalier direction of British politics since 2016 reached its financial apogee. Any merits – and there were some – to the focus on economic growth were entirely overshadowed by our latest leaders making plain their disdain for convention and restraint.
Gilts fell, as did the pound. Pension funds caught offside liquidated holdings. Assets went into a tailspin. There were fears of a Death Spiral. A fire sale of Britain’s fiscal silverware that would force still more selling, metastasizing the crisis until it even threatened the banks.
We’d been there once before this century. Nobody wanted another T-shirt.
Fortunately Britain’s biggest bank was having none of it. The Bank of England stepped in to shore up the system – yet it defied the shrieks from certain perma-delusional Brexiteers and warned its support was temporary. The Old Lady was not going to monetize the bill for Basket Case Britain.
But something had to give, and it turned out to be the chancellor – followed by the Prime Minister. In a month Britain had new iterations of both, this time singing from a more conventional hymn sheet.
The Tories were chastened. They would do anything to get off the naughty step.
The markets believed them and the stresses in the system melted away.
How the bodies were buried
Given all the high drama – and the uncomfortable optics of bond vigilantes and arguably even the Bank of England governor forcing political change – what is most remarkable just ten weeks later is how much the damage has been repaired. At least from the perspective of the City of London.
Look at the bond markets and you’d never know it happened. The pound is up a lot. Market trading is orderly. And if any big beasts were fatally wounded by the ructions then we’ve yet to find out.
It’s a slightly different story for us little guys though – especially those of us with mortgages.
Let’s take a ride through the scenic route to see just how acute the episode was.
Index-linked government bonds, aka index-linked gilts, aka ‘linkers’
When I do my retrospective of the 2020s in eight year’s time (put it in your calendars, Monevator fans) index-linked gilts will be the poster child for the Kwamakazi experience.
I’ve already shared this Tweet from the height of the crisis:
It’s still hard to believe that index-linked gilts – supposedly the most staid asset class in a UK investor’s toolbox – fell so precipitously. That’s forced selling for you.
The longest-dated linkers saw the most dramatic declines. That iShares ETF has sported a duration of around 20 for most of 2022 (duration has declined as yields have risen) but there exists an index-linked gilt that won’t mature until 2073. Its duration is nearly 50!
The price decline for that one has been absolutely brutal this year:
Yet in a reminder that things can always get worse in investing, even after its price had fallen by two-thirds in 2022, this linker still almost halved again following the Mini Budget.
Shocking – yet those of you with your glasses on might also notice the price is now back above where it sat on 23 September. The painful event has been erased.
Blink and you missed it
Returning to the iShares ETF tracker INXG, its price is now back to bouncing around just below £15.
Anyone brave enough to buy in the maelstrom might have seen a 35% gain in a matter of weeks. This from one of the world’s supposedly dullest investments, and in an awful year for profitable investing.
Moreover for a heady moment in late September you could buy a 30-year linker with a positive real yield of 2%. That’s like buying a £2,000 annuity for £100,000 – but without giving up your capital!
Me and The Accumulator started exploring index-linked gilt ladders that could create a near-risk-free retirement portfolio with a nailed-on Safe Withdrawal Rate.1 We almost wrote about it.
But then, in a flash, the Bank of England’s interventions worked and real yields on linkers went negative once more. Not as bad as 12 months ago, but you were paying for inflation protection again.
Prices have actually eased a little since then, but nothing like enough to make index-linked gilts screaming buys. Most linkers are back on slightly negative yields to maturity. The asset is once more just an expensive but uniquely diversifying component to add to a well-rounded portfolio.
I have never fielded so many questions and opinions from friends and Monevator readers about bonds as this year.
Strange in a way, given that the scene was set by the previous ten years. But most people didn’t seem to think about where their almost metronomic bond returns came from as yields fell and prices rose for a decade.
Frogs were boiled and we forgot how weird really low interest rates were. And anyone who did ever wonder whether yields were finally turning was soon slapped in the face by market reality, as bonds relentlessly refused to crash.
But 2022 has changed all that. From a UK perspective, the Mini Budget crisis was peak Bondageddon.
I know you’re supposed to illustrate this with yields and I will in a moment. But as we’re private investors around here, let’s see how the iShares Core Gilt ETF price has done since June:
For sure it had been falling ahead of that fateful 23 September. But the big lurch down you see – to £9.56 a share, per Hargreaves Lansdown – occurred in the week after Kwarteng spoke.
The price is now back around £11.
The moves have not been as dramatic as for linkers, and on the face of it there’s more value around in the conventional gilt market. Most issues are still priced below par after 2022’s declines, and it’s easy to get a 3% or higher yield to maturity. (Even the iShares ETF will give you that).
Of course, there aren’t supposed to be ‘bargains’ in the super deep gilt market. So if these bonds do look slightly better value than linkers, it may be because they are telling us something about inflation.
On the other hand maybe pension funds have to replenish their index-linked store cupboards and they don’t mind overpaying.
For a moment the Mini Budget made bonds a bargain
Either way, an attractive 4.5% yield on a 10-year gilt was a blink and you missed it Mini Budget moment:
I have an investing-savvy friend who got interested in bonds for the first time in his life when the yield breached 4%.
My friend has nine years left on a ten-year fixed-rate mortgage deal. From memory, his rate is a little over 2%. Even as he was helping his kids pack for a holiday, my chum was looking to rejig his portfolio to liability-match away some of that mortgage risk and profit from the 2% differential.
But he snoozed and he – ahem – loozed.
(Probably not in practice, as my friend bunged the earmarked money back into a hedged global tracker in the end, which is likely to do far better over nine years. But it will be a very different ride.)
Bonds still look more attractive than they have for years. However that’s a low bar. On these yields they are fine assets for diversification, but I wouldn’t go overboard, personally, and would favour a good slug of cash in the mix.
Mortgage madness
Discussion of bonds and yields moves us naturally on to mortgages. And here the damage inflicted by the Mini Budget has yet to be entirely ameliorated.
Sure, mortgages don’t move in lockstep with bond yields. They are more determined by so-called ‘swap’ rates.
Swaps are basically ways in which financial institutions transform and trade different kinds of interest rate risk to suit their needs.
Swap rates are mostly determined by the yield curve, as are bond yields, so it’s all relevant. (Some people will tell you it’s all the same thing – ‘interest rates’ – but I prefer to think of a kind of Platonic yield curve that all these variables are oscillating around. But we’re getting into the weeds…)
Banks consider more than the prevailing swap rates when pricing their mortgages. They also take into account how risky they feel the lending landscape is, and how much business they want to do.
And during the Mini Budget mayhem, they pretty much decided ‘sod all’ was the appropriate level.
Fixed-rate mortgages skyrocketed as swap rates spiked. Hundreds of mortgage products were pulled.
The following graphic shows how mortgage rates were slow to follow swap rates back down. (It will be particularly interesting to the finance wonk reader who even now is furiously typing a comment in response to my earlier broad-brush descriptions. You see? Swap rates aren’t actually everything):
Rates up, prices down: for bonds and maybe houses too
The good news is fixed mortgages rates have declined further in the month since that graphic was created.
Just last week the rate on a five-year fix fell below 6% for the first time since October.
The bad news is these rates are still much higher than before 23 September. Not only has that caused lots of people to lock into higher mortgages than they otherwise would have, it’s also dinged the housing market.
This shouldn’t be surprising given the hit to affordability of going from 2% to 6% on today’s huge mortgages. (Although it does seem to come as a surprise to many Boomers still dining out on their far higher rates – but much lower balances – of 30 years ago.)
I wonder if doing the sums on higher rates will have a lasting affect on home buyers, even if rates continue to decline. Perhaps they have looked into the abyss of potentially needing to sell a kidney to meet their mortgage payments and pulled back?
Lower mortgage rates would still be welcome, even if it’s too late to prevent a hit to house prices. Consumer spending will need all the help it can get in 2023.
The Pound
Much was made in the midst of the Mini Budget brouhaha of the decline in the value of Sterling. Hardly surprising, given the exchange rate almost touched $1.03 on the following Monday.
However it always takes two to tango with exchange rates – since they must be quoted in pairs.
Sure, some of the decline in the pound reflected international capital calling time on Britain’s political antics. But a fair bit of it was dollar strength.
Here’s how the pound has fared against the dollar and the Euro over the past six months:
Source: Google Finance
You can see a late September swoon against both the Euro (yellow) and the dollar (blue). But the move against the greenback is swoonier. Other things were going on at the time that made the US dollar even more attractive.
You’ll also note the pound is now back above pre-Mini Budget levels against both currencies.
Tomorrow I’ll wake up in the shower and realize it was all a dream.
The Mini Budget and pensions
Other lingering impacts? What about pensions and all that Liability Driven Investing (LDI) business?
Some experts reckon there has been a long-term hit to the funding of some pension schemes from their forced selling in September.
Professor Iain Clacher told MPs last week there was “probably £500bn missing somewhere” :
“This is not a paper loss, this is a real loss, because pension funds were selling assets to meet their collateral calls.
What we’ve actually seen is a significant reduction in the overall pot of assets that are available to pension funds to pay pensions in the fullness of time.”
That seems to make sense. It’s also plausible that nobody has made much fuss about it, because scant few of us really understand pension funding and many schemes were in deficit for years anyway.
Pension schemes affected by LDI might well want to avoid spooking their members – and regulators – unless and until they have to. (Higher yields in 2022 had previously improved the funding picture, which will help.)
But a potential portent of real damage came just yesterday. According to the Financial Times:
Lloyds Banking Group’s pension scheme sold billions of pounds of assets to meet collateral calls during September’s market crisis, one of the biggest known sell-offs by a corporate plan.
Details of the scale of asset disposals were revealed in a submission made to the work and pensions select committee by the partner of the head of Lloyds’ £52bn retirement scheme.
In evidence to MPs, Henry Tapper, founder of AgeWage, which provides pension market analysis, said he lived with the chief executive of a large defined benefit plan […]
“Much of the money posted as collateral won’t be seen again, the assets of the scheme are depleted and much money has been spent in the liquidation process,” wrote Tapper. “I understand the scale of the collateral call ran into billions of pounds.”
Tapper’s partner, Stella Eastwood, is reportedly head of pensions at Lloyds. The FT reports that Lloyds’ three defined benefit plans have around 47,000 members.
Waking up from the Mini Budget blues
Sitting here at the start of December, the Mini Budget feels like a nasty disease we got through.
The symptoms have mostly gone away. But it knocked us back and we still don’t feel quite right.
The economy is headed for recession. It was probably going that way anyway. But the rise in borrowing costs has likely nailed it on.
Overall I think Britain dodged a bullet. You can imagine scenarios where the markets weren’t so quickly calmed. Maybe if the Tories hadn’t got their act together with that solid Mr Hunt, or if the Bank of England had dithered.
Nobody likes austerity much – touted as the main political fallout from this strange roundabout trip. Although as things stand austerity is mostly still a future promise, perhaps made more to calm the markets than for a manifesto.
It’s also hard to foresee a risky agenda focused on growth and productivity being tried again anytime soon. A shame because we need both.
But we’ll have to take our lumps if the alternative would have been a lasting meltdown.
I say ‘nearly’ risk-free because unlike US TIPS our linkers do not have zero floor in case of deflation. [↩]
