Bonds

What is a bond?

A bond is a fixed-income investment where investors lend money to governments or companies for a set period of time in return for regular interest payments.

How do bonds work?

In most cases companies turn to banks to take out business loans. However, through bonds, it’s possible to turn to investors with cap in hand too.

In return for the loan, the borrower will agree to pay the lender regular interest payments – usually once or twice a year. These are called coupon payments.

When the bond ends, also known as the maturity date, the original investment loan is paid back to the lender. Most bonds are issued with long-term borrowing in mind, between 5 and 50 years.

Bond example

Let’s say you invest £10,000 into a 10-year government bond at launch with a 5% annual coupon. Each year the government will pay you 5% of your investment as interest (£500). At the end of the 10 years, your original £10,000 investment is returned.

The interest rates used for the example aren’t reflective of the current interest rates for most bonds, but it keeps the maths easy.

Why do companies issue bonds?

A bond is simply another route to raise money for companies or governments, and it’s usually a cheaper option than borrowing directly from the bank.

Governments or companies look to raise money through bond issues for different reasons. This is why it’s always a good idea for investors to do their due diligence and read the prospectus before considering to take part.

Companies usually want to replace existing debt which is due to expire, or to fund future growth of the business – such as business expansions, takeovers or product development.

On the other hand, governments normally issue bonds to finance public spending, infrastructure projects such as roads or schools, or to inject money back into the economy through quantitative easing (QE). In the UK, bonds issued by the UK government are known as Gilt-edged Securities, or GILTs for short.

Bonds are an attractive option for investors looking to secure a relatively low risk, but reliable income. Or those that want to shelter the purchasing power of their money by achieving a rate of return similar to inflation – the rate at which prices for goods and services rise.

Bonds are often seen as a safer option when compared to shares, as the issuer will agree to pay a set amount of interest through the duration of the bond. For this reason, bonds can also be popular with insurance companies and pensions funds which have set liabilities to meet in the future.

Remember though, any income from investments is variable and isn’t guaranteed.

How are bonds traded?

Bonds can be traded in one of two ways.

1. Primary market – this is where bonds are traded strictly between the bond issuer and bond buyer before listing on a live exchange. Buying bonds through the primary market gives investors the opportunity to get in at the ground floor. They’ll pay a fixed price, known as the issue price or par value – usually £100 or £1,000 per bond unit.
2. Secondary market – once the primary offering has closed, bonds can be swapped hands between investors through the secondary market. They trade on a live exchange with market price, similar to shares. The price investors pay for the bond is dependent on the ups and downs of the market – you could pay less or more than the issue price.

If an investor buys a bond part way through its coupon period, there will be an adjustment for the income that has "accrued" to the bond. This is standard practice in the bond market and strikes a fair balance between buyers and sellers, as well as neatly differentiating between income and capital gains.

The difference between the primary market and the secondary market is a bit like buying a car brand new or second hand. There are pros and cons to both. The main focus as an investor should be to make sure you’re getting a good deal.

What are the risks?

All investments carry a degree of risk. Bonds are no exception. They can fall as well as rise in value so you could get back less than you invest. Bonds are generally seen as less risky than other investment types like individual company shares.

Bondholders need the government or company to have enough cash to repay the loan and service the debt, whereas shareholders rely on company profits and the fortunes of the stock market.

So, in terms of risk and reward, bonds generally sit between cash and shares.

Interest rate risk – interest rates and bond prices have a negative relationship. If interest rates go down, investors begin to favour fixed interest rates from bonds which pushes up demand and prices. The opposite is true when interest rates rise.

Inflation risk – bonds are at most risk to inflation (rate of price rises) as their interest payments are normally fixed. If inflation outpaces the rate of interest you receive from a bond, the purchasing power of your money will be worth less than it once was.

Default risk – there’s a risk the bond issuer won’t be able to repay the loan or interest payments – this is known as a default. Similar to if you miss any mortgage or credit card repayments.

The risk of the UK or other major governments being unable to repay their debts is low, but they’re not totally risk free. It’s not uncommon for corporate bond issuers to go bust, especially in smaller, less established companies.

If the bond issuer defaults, investors risk losing their entire investment.

Market risk – bond’s prices will go up and down from day to day. So, if an investor needed to sell a bond before the maturity date to raise money, there is a risk they could sell below the price they paid for it.

Relationship between bond prices and interest rates

Bond prices and interest rates tend to be like two passing ships – they move in opposite directions.

If interest rates rise, bond prices fall, all else being equal.

Why? When interest rates rise, it’s easier to earn better rates of interest from cash. This forces new bond issues to offer more appealing coupon rates for the added risk that comes with investing in bonds. With less demand for existing fixed-interest bonds, it ultimately leads to price falls – bond prices are based on supply and demand similar to shares.

Let’s take a look at an example.

ABC plc bond is willing to pay investors an annual coupon of 2% and the current interest rate is set at 1%. In others words, you’d receive an extra 1% as a reward for the extra risk of owning bonds over cash savings.

However, if interest rates jumped to 2%, ABC plc bond is now less valuable to investors. That’s because they could get the same level of return from cash, or even better returns from investing in new bond issues offering 3% for the same level of risk.

The above example is for illustration purposes only. Coupon rates and time to maturity can impact a bond’s price sensitivity to interest rate changes – this is something called duration.

The opposite is true when interest rates fall – the market value of bonds tends to rise.

Existing bonds on the market become more precious to investors as new bond issues have less favourable interest rates, and you earn less interest from cash sat in your bank. This causes bond prices to rise. But as a bond’s price rises – its yield falls.

During the financial crisis in 2008, lots of central banks drastically cut back interest rates in an attempt to breathe life back into the economy. This led to the bond markets performing strongly over the last decade. However, yields are now at very low levels, which means the income on offer for investors is in short supply.

In recent times, central banks have increased interest rates to combat soaring inflation rates. This has sparked a fall in bond prices, and a rise in bond yields, which increases the potential for capital losses for bond investors.

Do bonds have inflation risk?

While inflation doesn’t share the same direct relationship with bonds in the same way as interest rates do. It’s the see-saw relationship between inflation and interest rates that can send jitters through bond markets.

A little bit of inflation isn’t necessarily a bad thing, it can boost growth in an economy that might be stuck in a recession for example.

However if inflation begins to spiral out of control, it can become difficult for businesses to set the right prices for goods and services. Employees’ wages are worth less in real terms too, which can lead to wage rises, which can trigger further inflation. It’s a vicious cycle.

That’s why central banks use raising interest rates as a remedy to inflation.

Higher interest rates make it more expensive to borrow money, encourages people to save more and therefore spend less in the economy. This lowers the demand for goods and services and helps keep price rises lower. And we’ve already talked about why rising interest rates impact bond prices.

It’s important for investors to remember that market headwinds, like inflation or interest rate rises, are part and parcel of investing (it’s never plain-sailing). Staying diversified and investing for the long term – that’s at least five years or more – are two of the most effective ways to help navigate any market storms.

Investing in bonds

Bonds are an attractive option for investors looking for regular income. But they’re more than a one-trick pony.

Bonds are seen as ‘safer’ investments – they tend to be less volatile than shares which can offer some shelter during market wobbles. This means they could act as part of the core of a conservative portfolio. They can also add some balance to an adventurous portfolio mostly invested in company shares or share-based funds. Remember though lower risk usually means lower reward.

Investing in individual bonds can be very complex with complicated pricing structures. Some bonds, like index-linked bonds, which offer investors shelter from inflation, often require a large initial lump sum investment which isn’t always suitable for retail investors.

For investors looking to dip into the bond market, we think bond funds could be a good option.

Bond funds invest into a basket of bonds which are hand-selected and run by a professional fund manager. Investors in the fund benefit from their expertise, knowledge and time spent researching for the best opportunities in the market. It’s also possible to invest in bond tracker funds which aim to track the performance of the wider market like-for-like.

Better still, you don’t need to have deep pockets to get started either. You can invest in funds from as little as £25 a month by direct debit or with a £100 lump sum through HL – offering an easy and convenient way to invest.

We think bonds should play at least some part in investors’ portfolios as a way to manage risk. They might not offer the most exciting way to invest, but investing isn’t a game and ignoring them completely could make for a painful watch if markets take a tumble.

You’ll need to consider your own goals and attitude to risk before making any decisions. Investing in bonds or bond funds won’t be right for everyone – all investments can fall as well as rise in value so you could get back less than you invest.

For more information on bonds, read our latest review on this sector which includes information on our Wealth Shortlist bond funds. The Wealth Shortlist is a list of funds selected by our analysts for their long-term performance potential.