Investing Basics: What are Bonds?
Unlike a share, where investors literally buy a share in a company’s profits, a bond is an ‘IOU’ from a company to an investor who loans it money; Christian Leeming considers why DIY investors may wish to hold them in their portfolio.
Bonds guarantee to pay a fixed rate of interest over a fixed period; the rate of interest and duration of the loan is set when the bond is issued, which is why bonds are sometimes known as ‘fixed interest’ investments, or ‘debt securities’.
Interest is paid via a series of annual or semi-annual ‘coupons’, and once the bond reaches its expiry date - ‘maturity’ - the issuer is obliged to pay back the bondholder their initial investment in full.
Bonds originally had detachable, individually-numbered coupons which investors would send to the issuer to claim their payment, hence the term; today, interest payments are made electronically into your account.
A bond is form of investment which usually offers little potential for capital growth, but delivers regular income to the investor while he or she holds it.
Who can issue bonds?
Bonds can be issued by a corporation, a government or non-government organisations like the World Bank, to raise money.
The amount of income that bonds pay reflects the ‘risk premium’ attached to them; the riskier a company (or country) is, the higher the coupon its bonds will offer.
Very large and well established companies with solid earnings and high ‘ratings’ from agencies tend to pay a lower coupon – because the risk premium attached to owning their bonds is lower.
Government bonds, also known as ‘sovereign bonds’ or ‘gilts’ (those issued by the Bank of England), tend to pay lower coupons still – the theory being that countries are even less likely to collapse than corporations.
Gilts in the UK or ‘treasuries’ in the US, have traditionally been seen as the most secure and as such are used to benchmark the bond market; they are by far the biggest issuers and as long as they borrow in their own currency they should always be able to print more money to pay the coupon.
Ratings agencies such as Standard and Poor’s, Moody’s and Fitch provide a guide to credit quality – the likelihood of the investor being repaid – by grading bonds in descending order from AAA to AA+, AA, AA-, BBB+ etc.
‘Investment grade’ bonds are those rated BBB and above; investors can achieve higher rates of interest by buying ‘high yield’ or ‘junk bonds’ – but only if they avoid those companies that go bust.
Well-known international companies are seen as likely to pay bondholders back and their bonds typically have quite low interest rates; companies in a poor financial situation, or already saddled with a lot of debt, typically need to pay much higher interest rates to compensate investors for the additional risk of buying their bonds.
In February 2010 the London Stock Exchange (LSE) launched the Order Book for Retail Bonds (ORB) with the objective of making a new generation of retail bonds accessible to the retail investor and providing liquidity in the secondary market for those that did not wish to hold the investment to maturity.
Most bonds issued on ORB offered a relatively low minimum investment, typically £2,000, and with relatively generous rates of interest were in demand for those investing for income; unfortunately issuance was scarce and some were lured by the siren call of unregulated mini-bonds to their great cost. See Retail Bond Expert
What is yield?
Whereas shares are quoted on the basis of price, bonds are bought and sold on the basis of their ‘yield’.
Bonds are issued at ‘par’, or 100% of their face value, and assuming the issuer doesn’t go bust they are also redeemed at face value.
The rate of interest paid by the bond is set when it is issued so the yield is that rate of interest relative to the bond’s price in the market; most bonds trade either above or below ‘par’ for most of their lives as markets rise and fall.
If a bond with an interest rate of 5% is trading at ‘par’, its yield is 5%; if the bond trades below ‘par’, the interest rate will be more than 5%, and if it trades above ‘par’ the interest rate will be below 5%.
There has been increasing demand for bonds over the last couple of decades, which has meant that the interest rates companies have paid to issue bonds has decreased; it has also meant that yields on bonds have reduced as more people compete to buy them, forcing prices up.
In most instances, the longer the period to maturity, the greater the return on the bond, which is compensation for the risk posed by the longer holding period; today, gilts which pay out after just a month offer a yield of 0.21% whilst those with a 20-year term offer 0.64%. Price volatility also tends to be higher on longer-dated bonds.
Particularly for government debt the lifespan can be very long indeed; gilts come in three main maturity dates – 0-7 years, 7-15 years and 15 years or more, with some in excess of 50 years.
What are the pros and cons of bonds?
A key advantage of bonds compared with shares is that if a company goes bust shareholders could lose all of their investment as shares only entitle you to a share of the profits; bonds are a claim on a company’s assets instead.
If the company goes bust bondholders have a chance of getting something back, although they rank below the banks and trade creditors in terms of being paid, and the type of bond you hold determines how much of your money you might get back.
Another advantage of bonds is that they tend to be less volatile than shares, although the trade-off is that over the long term shares perform better.
For DIY investors, investing in individual government and corporate bonds is not as straightforward as shares; most investment platforms require you to trade bonds over the phone rather than online and corporate bonds often have to be traded in denominations of £10,000 or more and are typically harder to sell than shares.
Alternatives are provided by funds and investment trusts which invest in fixed income and exchange-traded funds (ETF) which track different baskets of bonds; these have the advantage of providing diversification too.
For those investing for income, bonds are likely to be a cornerstone of their portfolio; there is an ‘age-old’ rule of thumb which states that income investors should hold a proportion of bonds in line with their age -aged 30, 30% of your portfolio should be in bonds whilst at 60, it should be 60%.
For more about fixed income visit DIY Investor
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