Bonds explained simply: Is now the right time to invest?

For many years, bonds were probably the least attractive investment of all: zero interest and price losses on top. Until recently, that is: after the Swiss National Bank turned the interest rate screw hard, inflation in Switzerland appears to be under control. And so a growing number of voices believe that the interest rate turnaround is already over again. So are we about to see a revival of these once so popular fixed-income securities? In this article, we take a closer look at these and other questions around “bonds explained simply”.

Bonds explained simply

Bonds are fixed-income securities issued by issuers (debtors) such as companies, governments or other institutions in order to raise capital.

The term “Obligation” is mainly used in Switzerland, while “Anleihe” is the common synonym in Germany and “bond” internationally.

When you buy a government bond or a corporate bond, you lend the issuer money for a fixed term and at a fixed interest rate. This so-called coupon is paid out to you regularly (often once a year).

With Swiss bonds, 35% Swiss withholding tax is deducted, which you can reclaim in full by declaring it in your tax return.

At the end of the term, the issuer undertakes to repay the security’s nominal value.

Depending on the issuer, there are different types of bonds:

• Government bonds: a state is the debtor.
• Medium-term notes: a bank is the debtor (bank debt securities).
• Corporate bonds: a private company is the debtor (company bonds).

If you don’t want to wait until the end of the term, you can sell the bond at the bond price. If you sell early, however, you have to expect price discounts. Many bonds can be traded on the stock exchange.

Swiss bond market: the wind has turned

The popularity of bonds depends heavily on the level of interest rates. This currently stands at 1.75% (key interest rate), the highest since 2008.

In response to rising inflation, the Swiss National Bank (SNB) initiated the interest rate turnaround on 22 September 2022. In other words, with this rate move, key interest rates returned to positive territory for the first time since 2014 and then rose step by step to today’s 1.75%.  

Recently, however, more and more voices have said that interest rates have already peaked. On 20 November 2023, for example, the Tages-Anzeiger ran the headline “Key interest rates are likely to fall again soon”.

This forecast is based mainly on the fact that inflation had recently fallen to 1.4% (November 2023). That puts inflation well below the 2% threshold targeted by the Swiss National Bank. If this level can be held, further key rate hikes would no longer be necessary.

In this article from 4 December 2023, however, the NZZ expects inflation to reverse its trend soon. It also cites an SNB forecast according to which inflation could climb back above 2% as early as the beginning of 2024.  

As we all know, high interest rates are a double-edged sword: savers love them, while debtors in business and society (e.g. mortgage borrowers) suffer from them.

In this article, “Bonds explained simply”, we want to focus on those who benefit from interest rates and take a closer look at this old and once so popular savings classic.

In the next chapter, we look at the (often underestimated) risks of bonds.

What risks do bonds involve?

The creditworthiness of the issuer is the most important risk factor. In general, government bonds from countries with a good credit rating are considered safer, while corporate bonds can carry a higher risk, especially if the company is financially unstable. The latter are known as junk bonds, i.e. speculative, high-yield bonds from issuers with a poor credit rating.

Besides the credit risk mentioned above, you need to pay particular attention to interest rate risk with bonds, which is often underestimated. Specifically: rising interest rates lead to falling prices and vice versa.

Interest rate risk can be measured with the “modified duration”. This risk measure indicates by what percentage the bond price fluctuates when the market interest rate level changes by one percentage point. A modified duration of 4 therefore means that the bond price falls by 4% if interest rates rise by one percentage point, or rises by 4% if they fall by the same amount.

If you hold a bond until maturity, you will get back the amount invested (nominal value at a price of 100). Even so, you still take on interest rate risk in this case: if the fixed coupon falls below the market rate during the holding period, you have to accept lower returns (compared with the market rate at that time).

You should also keep an eye on liquidity risk. This means that, for lack of demand, you might not be able to sell early, or only at a steep discount.

Finally, you take on currency risk when you invest in foreign bonds.

Despite these risks, bonds are considered a safer asset class than shares.

Why should I invest in bonds at all?

Bonds with a first-class credit rating – and these are what this article is about – are among the best-known asset classes in multi-asset portfolios thanks to their low volatility and low default risk.

There, together with the classic bank savings account and the fixed-term deposit account, bonds cover the low-risk part of your assets. In doing so, they contribute to better diversification of your portfolio.

But in times of negative and low interest rates, the yield on Swiss bonds tended towards zero, which is why they were considered unattractive for many years. At least until recently.

As customers of Viac, we too noticed that a bond revival is evidently under way. This year, the Swiss pension pioneer added bond ETFs to its investment universe – for the first time since it was founded in 2015! Before that, anyone who wanted to invest their pension money, or part of it, at low risk could only do so via the “cash” asset class. (If you’d like to get a small bonus as a new Viac customer, just send us a message at [email protected].)

Understandable – after all, why should I prefer bonds to cash if they come with higher risk and worse performance?

In which market phases are bonds attractive?

Basically, bonds pay off if interest rates fall unexpectedly after you buy them. (If falling prices are already expected, as they are today, this forecast is already priced into the coupon.) Because unlike a savings account, whose interest rate is continuously adjusted to market conditions, a bond scores with a fixed interest rate that is above the market rate when rates are falling.

Interest rates on medium-term notes

Runtime	ZKB*	PostFinance**	BPS (Suisse)***
2 years	1.05%	1.05%	1.375%
3 years	1.05%	1.00%	1.375%
4 years	1.05%	1.00%	1.375%
5 years	1.05%	1.00%	1.375%
6 years	1.05%	1.00%	1.375%
7 years	1.10%	1.05%	1.375%
8 years	1.10%	1.05%	1.375%
9 years	1.15%	1.10%	1.375%
10 years	1.15%	1.15%	1.375%

*ZKB with a rating of "AAA"; 5,000 CHF minimum deposit; 0.1% custody fees per year;
**PostFinance with a rating of "AA"; 5,000 CHF minimum deposit; no custody fees;
***BPS with a rating of "BBB"; 1,000 CHF minimum deposit; no custody fees; all interest rates as of December 1, 2023 (Sources: provider information online).

The fact that the interest rates in the table above remain virtually unchanged even over longer terms suggests that interest rates are no longer expected to rise.

It is also striking that the interest rates on offer are very low, i.e. comparable to those of savings accounts. BPS does pay a higher rate, but its default risk is also higher because of its much weaker credit rating.

Sure, if you took out a medium-term note at 1% today, that interest rate would be guaranteed for the entire term, whereas the interest rate on a savings account is continuously adjusted to the market rate – in other words, in an extreme case it could drop back to zero.

Conclusion on medium-term notes

Medium-term notes from issuers with a high credit rating undoubtedly meet the requirements of a low-risk investment. But the low interest combined with limited liquidity, the need to open a securities account and minimum amounts make us look for better alternatives.  

Are bond ETFs the better choice?

The advantages of bond ETFs are obvious: no concentration risk regarding the issuer’s creditworthiness and usually better liquidity. But we also see a drawback: no predictable return, i.e. like equity ETFs, bond ETFs are a black box when it comes to performance.

An attempt at an explanation: if, for example, you subscribe to a medium-term note worth CHF 10,000 with a 5-year term from Zürcher Kantonalbank, which has the highest credit rating, you currently receive interest of 1.05% (see also the table above). This means you can determine the value of your investment precisely at the end of the term: CHF 10,525, i.e. the invested amount of CHF 10,000 plus five interest coupons of CHF 105 each. With bond ETFs, by contrast, the expected return depends crucially on how market interest rates develop.

A (risk-averse) investor who doesn’t want to take on price fluctuations would probably rather go for individual medium-term notes and hold them until maturity.

Unlike medium-term notes, bond ETFs can also be quite volatile. As a rule of thumb, long-dated bonds and, because of currency risk, bonds in foreign currencies fluctuate more than short-dated or domestic securities.

If we go back a little further and compare the annual performance of the last five years, there are considerable differences here too. The ETFs exposed to currency risk (see the last two rows) and those with long remaining terms (see the last column) fluctuate the most. 

Bond ETFs in the yield check

ETF product title (description)	ISIN	2019	2020	2021	2022	2023*	AR**	MD***
iShares Swiss Domestic Government Bond 1-3 (CH government bonds with remaining maturity of 1-3 years)	CH0102530786	-1.18%	-0.85%	-1.13%	-2.78%	0.49%	1.96%	1.66
iShares Swiss Domestic Government Bond 3-7 (CH government bonds with remaining maturity of 3-7 years)	CH0016999846	-0.54%	-0.45%	-2.05%	-7.69%	3.12%	1.91%	4.83
iShares Swiss Domestic Government Bond 7-15 (CH government bonds with remaining maturity of 7-15 years)	CH0016999861	2.60%	0.57%	-3.35%	-14.19%	8.39%	1.16%	10
iShares Core CHF Corporate Bond (CH corporate bonds)	CH0226976816	2.68%	0.29%	-0.48%	-9.00%	4.67%	0.67%	4.31
iShares Core EUR Corporate Bond UCITS (Corporate bonds in the Eurozone)	IE00B3F81R35	2.41%	2.06%	-5.33%	-18.16%	2.69%	2.66%	4.42
iShares Global Corporate Bond UCITS USD (Global corporate bonds)	IE00B7J7TB45	9.34%	0.24%	0.12%	-15.62%	0.36%	3.48%	5.7

All returns include distributions and are based on CHF, i.e., they account for currency risks (data source: justetf); all corporate bonds with investment-grade ratings; *YTD 1.1. - 30.11.; **AR = Distribution yield over the last 12 months; ***MD = Modified duration in years (data source: provider fact sheets).

As the table above clearly shows, light and shadow can be close together in time. While 2023 looks set to be a pleasing year for bond ETFs, the year before was dismal, with losses in value of up to 18%.

Conclusion on bond ETFs

Neither long-dated bond ETFs (interest rate risk) nor foreign ones (currency risk) are suitable for low-risk investing. In our view, therefore, only short-dated bond ETFs in your home currency come into question, as they are comparatively stable in value. But their performance is disappointing, which is why we will continue our search for more attractive savings options in the next chapter.

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What savings alternatives to bonds are there?

None of the securities we have looked at so far, whether medium-term notes from individual banks or broadly diversified bond ETFs, convinces us. This disappointing interim conclusion motivates us to look for alternative ways to save.

One thing still applies, though: savings should cover the low-risk part of your assets, i.e. of your asset allocation. This includes an emergency fund for unplanned events just as much as savings goals with a clear deadline, such as a trip around the world for a milestone birthday.

Savings are characterized by a high level of security. We see the two most important goals of savings as capital protection and wealth preservation.

Capital protection is ensured by first-class safeguards. For a bank account, this is primarily deposit insurance of CHF 100,000, while for bonds a high credit rating of the issuer is what counts.

Wealth preservation, in turn, is about protecting savings against inflation. Ideally, savings should therefore also preserve their purchasing power in the long run.

With the current inflation rate of 1.4% (as of November 2023) and current savings rates of around 1%, this goal is not quite achieved – in other words, savings shrink a little each year in real terms.

So let’s take a closer look at two savings options that could serve as alternatives to bonds:

Savings alternative “fixed-term deposit”

Unlike the security “bond”, a fixed-term deposit is an account solution. That’s why it is also covered by deposit insurance of up to CHF 100,000. As with a bond, a fixed-term deposit pays you a fixed interest rate for a set term.

The current interest rate is a modest 1% or so. The term usually ranges from one month to one year. During this time your money is tied up, i.e. you can’t access it.

Fixed-term deposits have another, even bigger catch, though: high entry barriers. Even at the down-to-earth Migros Bank, the minimum deposit is a hefty CHF 100,000.

High entry barriers and no early withdrawal options are two compelling reasons why, for us, fixed-term deposits are not a viable alternative to bonds.

Savings alternative “savings account”

That leaves the good old savings account. Like a fixed-term deposit, it is covered by deposit insurance of up to CHF 100,000. Besides security, the savings account stands out for its high liquidity. This means that, depending on the bank, there are few or no restrictions on accessing the money you have saved.

Unlike with fixed-term deposits and bonds, on a savings account the interest rate is variable, i.e. it continuously adjusts to market conditions. Compared with a bond, this is an advantage when prices rise and a disadvantage when they fall.

In addition, savings accounts generally require no minimum amounts.

For these reasons, we see the savings account as an interesting alternative to bonds.

In our experience, the Swiss smartphone bank Yuh offers a savings solution that is particularly attractive in terms of flexibility and liquidity (see also our review “Yuh review: what the new star in the Swiss neobank sky has to offer”).

There you currently receive 1% interest on your entire CHF cash balance, with no withdrawal or amount limits. Unique: for the interest, it makes no difference whether you keep your cash in the “Pay” or “Save” area of the app. It doesn’t get any simpler! If you’d like to save with Yuh too, you’ll get a trading bonus of CHF 50 with our promo code “YUHSFB”.

Final conclusion on “Bonds explained simply”

To be honest, we had imagined a different final conclusion. Before our analysis, we had expected to be able to make a clear recommendation for the “bonds” asset class.

But the overall package of unpredictable interest rate risk, low interest and limited liquidity failed to convince us – neither with individual medium-term notes nor with broadly diversified bond ETFs.

We have therefore concluded that saving with a savings account is more attractive overall. This is especially true with innovative providers such as Yuh, which offer comparatively high interest along with the greatest possible liquidity and flexibility.

Being able to access your cash at any time is crucial, especially for the savings goal “emergency fund”, because by its very nature it can’t be scheduled. And that’s where the good old savings account is clearly ahead!

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Disclaimer

Disclaimer: Investing involves the risk of loss. You have to decide for yourself whether or not you want to bear these risks.

Errors excepted: We wrote this article “Bonds explained simply” to the best of our knowledge and belief. Our goal is to provide you as a private investor with information on finance that is as objective and meaningful as possible. If we have nevertheless made mistakes, or if important aspects have been forgotten and/or are no longer up to date, we would be grateful if you let us know.