WHAT IS A BOND?

The sterling fixed income markets offer investors a wide choice of assets ranging from the security of government-backed Gilts through to more speculative, and higher yielding corporate bonds.

ISAs and SIPPs are increasing the demand from private investors for income-producing assets, and new ways of buying and selling bonds means they have never been more accessible.

Important information: this section of our website aims to help you understand and use this important asset class, it is not personal advice. Neither income or capital is guaranteed, the value of investments can fall as well as rise and you could get back less than you invest. Tax rules can change and the benefits depend on your personal circumstances. Bonds may not be suitable for all investors, if you are unsure of their suitability for your circumstances please ask for financial advice.

What are bonds?

Bonds are investments representing the debt of a government, company or other organisation. Effectively they are loans, or "IOUs" issued by these organisations and bought by banks, insurance companies, fund managers and private investors.

Investors are often heard to say "I don't understand bonds", but the truth is they can be much simpler than shares.

What are the key factors of bonds?

Issuer - This is the entity which is borrowing the money. For instance, £500 million will be borrowed, and £500 million of securities will be issued by the issuer. Typically these will be launched at "par" or 100p in the pound.
Coupon - The issuer commits to pay a rate of interest of "X" % per year. This coupon will generally be a fixed amount and is paid annually or semi-annually.
Maturity - A date is set for the repayment of the money. This is known as the maturity or redemption date. The bonds will be redeemed at "par" or 100p in the pound (with some rare exceptions). However, if the issuer fails you might lose some or all of your investment and the income could stop.

At launch, bonds are sold to investors via an investment bank or broker. This is known as the primary market. Gilt issues are also offered directly to the general public. After this primary phase, bonds can be traded between investors and/or market counterparties. However, unlike equities that trade through a centralised stock exchange, bonds generally trade on a peer-to-peer basis from one institution (such as an investment bank) to another (such as broker).

This global bond market is enormous. The number of bonds in circulation is considerable, and issuers like the European Investment Bank may have several hundred bonds trading at any one time. These bonds will be issued in a variety of currencies and may differ greatly from each other in terms of coupon or coupon type, date of maturity and other features such as embedded put and call options.

What are the risks of investing in bonds?

All investments involve risk, and bonds are no exception. Investments can fall in value as well as rise and you could get back less than you invest. If you are unsure of the suitability of an investment please seek financial advice.

Risk of default

There is a risk that the issuer will be unable to return all or some of the capital and interest payments. In the bond markets this is known as a default. The equivalent in the equity market would be a company going bust, ceasing to trade, or being forced into administration.

Market risk

The bond's price will fluctuate from day to day according to the balance of supply and demand in the market, creating a paper profit or loss. Thus, if the investor needs to sell the asset before maturity to raise funds, there is a risk of capital loss.

Issue-specific risk

Many bonds are issued with imbedded features such as "calls", which enable the issuer to repay the debt ahead of schedule. This can be disadvantageous to the holder. Such features are clearly laid out in the bond's prospectus, investors should make sure they read a bond's prospectus prior to investing.

Event and other risks

This encompasses a variety of "operational" hazards such as a shift to an unfavourable or punitive tax treatment, remember tax rules can change and any reliefs depend on your personal circumstances. These types of risk can be reduced through careful planning and monitoring.

Included here are "event risks". An example of this would be the issuer of the bond becoming the target of a leveraged buyout - a buyout where by the company taking over the issuer is buying with the use of debt, increasing the degree of risk of lending money to the company. Finally, we add to this list the risk of inflation, which can devalue the asset or portfolio over time.

What are the different types of bonds?

These bonds are issued by the UK government in order to finance public spending. Gilt prices will fluctuate from day-to-day in the market, depending on the outlook for interest rates but investors who buy at par or below, and hold the bonds to maturity can be almost certain that interest and principal will be repaid in full, whereas if you buy above par and hold to maturity you will suffer a capital loss despite the government backing.
The majority of Gilts pay a fixed coupon (generally twice a year) and mature at a set date. This will vary from a few months to over forty years. The most popular Gilts for private investors are maturities between two and ten years. Some Gilts have more complex features such as "calls", which enable the government to pay off the debt ahead of time. Before purchasing a Gilt, it is worth checking the full details of the issue. Prospectuses for Gilt issues can be obtained via the website of the government's Debt Management Office.
Rather than paying a fixed coupon and amount on redemption, Index-linked Gilts' semi-annual coupon payments and principal are indexed to the UK Retail Prices Index (RPI). It is worth noting that there is a time lag on the RPI used to calculate the coupon and redemption period, however these instruments do offer a shelter against inflation. Because of the inflation-linking aspect of these bonds, Index Linked Gilts may show a wider movement of price over time.
This asset class covers the majority of GBP-denominated bonds other than UK Gilts.

These bonds may be issued by a variety of different types of issuers, including foreign governments, UK banks and medium-sized companies. As with Gilts, bond prices will move alongside the market's expectations for interest rates. However, the price (and thus the yield) will also be affected by the perceived credit quality of the issuer. If this is thought to be deteriorating, the price of the bond will fall.
These bonds are specifically issued for retail investors. They are denominated in pounds sterling (GBP) and can usually be bought in relatively small increments (typically £1,000). Like conventional bonds, retail bonds may be issued by a variety of issuers.

Retail bonds will be listed on the London Stock Exchange's Order Book for Retail Bonds (ORB) and can be bought and sold during normal London Stock Exchange opening hours. A retail bond's price will be affected by expected interest rate movements and also by the perceived credit quality of the issuer.
These are a type of instrument issued by UK building societies. Technically they are not bonds and usually carry a degree of subordination (rank below other debt owed by the issuer in the event of default). However, because of their fixed coupons they behave in a manner similar to bonds. Individual issues vary greatly and prospective clients should make sure they read the prospectus from the relevant issuer.
These are bonds where the coupon is not fixed, but based on a reference rate, since 2022 this is typically the Sterling Overnight Indexed Average (SONIA). They do not exhibit the same degree of interest rate sensitivity as conventional bonds. The majority of floating rate loans (FRNs) will be issued with maturities between two and ten years and will be senior debt. However, there is a class of perpetual FRNs which you may encounter from time to time of which the majority are subordinated debt (rank below other debt owed by the issuer in the event of default).
These are bonds where the holder may convert their redemption proceeds into the equity of the issuing company. Known as "equity convertibles", they can offer a combination of yield and growth for investors. These instruments may see their price driven higher by a rise in the company's equity. Risk, however, is generally higher.

In some cases, bonds may be issued with the option to convert into other bonds. These are a rather different kettle of fish and should not be confused with the "equity convertibles" above.
The majority of bonds issued are "senior debt", meaning the holder has a priority claim on the company's assets, ahead of shareholders in the event of the company being liquidated. Some bonds are issued with "subordinated" status. This means the buyer of the bonds accepts a lower claim on the company's assets, below senior debt holders, but still above shareholders. Because of the additional risk, a higher yield will be offered.

Why choose bonds?

Shares and bonds are very different kinds of investment. Shareholders own the company, bondholders simply lend it money.

This means the risk/reward profile is very different. Bondholders just need the company to have enough cash to repay the loan and service the debt. Profits could halve, ordinary dividends could be slashed but, as long as the company can meet its obligations to bondholders, they should continue to receive a fixed rate of interest and their capital back at redemption.

In terms of risk and reward, therefore, bonds generally sit between cash and shares.

Bonds and gilts offer security

The risk of the UK or other major governments being unable to repay their debts is low and government bonds should be considered superior in credit quality to a bank deposit in theory. In practice though the government underwrites bank deposits putting them on a par. High grade multi-national government agencies (such as the World Bank) also offer an extremely safe home for the investor holding bonds to maturity.

Of course, not all bonds are issued by governments. Many bonds are issued by companies and other organisations whose ability to service the debt may be less certain. However, even corporate debt can be considered a safer investment than the company's equity.

In the event of bankruptcy, bondholders are ranked above shareholders in their claim on the company's assets. However, if the company can't meet its obligations to bondholders, their capital and income is at risk.

Return of capital

Bonds also differ from equities in one other very important aspect. In order to realise your profit (or loss) on an equity, you are wholly dependent on the ability to sell the shares back to the market.

When an investor buys a bond, the redemption date and value is fixed in advance. Assuming the issuer is able to repay, the investor's reliance on the uncertainties of future market sentiment or liquidity is reduced.

Bonds can also be bought and sold in the secondary market after they are issued. A bond’s price and yield determine its value in the secondary market. This is an option for an investor who doesn’t want to hold their bond until redemption.

Reliable income

Bonds can add reasonably reliable income to a portfolio. The income available from bonds is generally higher than that available from equities. Also, future income payments are a relatively known quantity, unlike dividends from shares, which may be reduced or stopped in times of low profitability.

This generally makes bonds a good choice for investors who wish to shelter future income over a defined period of time. With bonds paying annually, semi-annually or sometimes quarterly, a carefully chosen bond portfolio with multiple holdings can produce a reliable monthly income.

Remember also that most bonds pay their coupons gross, without withholding tax. Investors can take advantage of this by holding qualifying bonds within an ISA, producing a tax free income. Remember tax rules can change and the reliefs depend on your personal circumstances, also that the income is not guaranteed and is dependent on the ability of the issuer to pay.

Diversify your portfolio

A well-managed portfolio should contain a variety of different assets classes. Equities, government bonds, index-linked bonds, corporate bonds, and alternative assets all have their role to play.

This simple approach of diversifying a portfolio is one of the most effective strategies for reducing risk. In certain economic scenarios, such as a recession, some bonds will offer a shelter against falling share prices.

Fixed interest rates

When an investor buys a fixed coupon bond, they lock in interest rates for a defined period. If interest rates rise, the income from a bond becomes less attractive and the market value of the bond will fall. Falling interest rates will cause the market value of the bond to rise. Investors who buy bonds in falling interest rate scenarios should receive the double benefit of a secure income and capital appreciation of their asset.

Speculation

Any financial instrument offers the potential to speculate on future price movements, and bonds are no exception. Liquid government bonds are often used by traders speculating on future interest rates while corporate bonds can see sharp price movements from changes in the perceived credit quality of the issuer.

Frequently asked questions

It is fair to say that bonds are generally less risky than equities. Price volatility in bonds is generally lower than that seen in equities. Risk adverse bond investors should restrict themselves to gilts and investment grade bonds and run a diversified portfolio.
Inflation is a major risk. Over longer periods of time this may erode the return of a bond portfolio, causing the value to fall in real terms. The outlook for inflation will have an impact on the market value of the bond and therefore if you sell before maturity it will impact on the value.

The prospectus for each bond will contain further details of risks.

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