It’s worth understanding what bonds are and how they work as they can play a key part in building an investment portfolio that balances risk and returns. They’re also a good way of generating an income from your investments.
Here we look at what bonds are, their benefits and risks, and how to invest in them. If you want to know more than just the basics, we take a closer look at some of the more technical details, including what affects bond values, yields and liquidity.
First of all, what is a bond?
Bonds are usually described as loans to institutions (governments and companies) that need to raise money. In practice, it means that when you buy a bond you’re giving your money to the government or company that has issued it for an agreed period of time.
In return, you’ll receive regular interest payments, usually known as coupons. And at the end of the agreed period you’ll get back the original amount you paid. For example, a bond with 10 years to maturity will pay out interest for 10 years from the date it’s bought. At the end of the 10 years (the redemption date), the bond issuer will repay the amount paid, and the interest payments will stop.
Remember bonds aren't risk free and unless you buy a guaranteed bond there is a chance that you won't get back what you originally paid in. We'll talk more about the risks later.
If you want, you can sell them before the end of the agreed period. But if you do that, the amount you get back will depend on how much the bond is worth on the open market – this will fluctuate depending on supply and demand, and other factors like interest rates and inflation.
You may also see bonds referred to as fixed interest or fixed income investments. That’s because you get interest payments at a set rate for a set period of time.
There are different types of bonds
Bonds issued by the UK government are known as gilts, while bonds from companies are called corporate bonds. Other government bonds you may hear about in the media are US treasuries and German bunds.
Why invest in bonds?
Including bonds in an investment portfolio, alongside other types of investments, can be an effective way of lowering your overall risk.
Bonds tend to behave differently to equities, so they’re good for spreading risk and, historically they’ve been less volatile than equities. However, at certain times they can be very risky, and the most risky types (long-term and high-yield) can be as volatile, or even more volatile, than some equities.
Bonds are often used to help spread the risk in people’s pension investments as they get closer to retirement. Long-term bonds specifically are used where people plan to buy an annuity with their pension when they retire, because annuity rates are linked to the price of these bonds. For example, an annuity targeting fund reduces the risk of your pension income falling as it invests in bonds whose prices are normally expected to rise and fall broadly in line with the cost of buying an annuity.
While this type of fund will protect your income at the point when you buy an annuity, your pension savings will still be exposed to risk, and can go down as well as up in value, as long-term bonds span a long investment period – and nobody knows what the future will bring.
Bonds can also provide a steady and defined income, as you receive a fixed level of interest but, bear in mind, that’s only if you hold them directly and sell them at their redemption date. And bondholders are ahead of shareholders in getting their money back if a company goes into liquidation. However, if you’re investing through a fund this might not be the case – so it’s important to check.
It’s important to remember that bonds aren’t risk free
Many investors use bonds to balance out the risk and return in their portfolios as they’re generally considered safer than investing in the stockmarket. But, as we’ve already mentioned, they aren’t risk free.
While it’s extremely unlikely that the UK government would ever default on its obligations to bondholders, there’s a chance that some companies or governments in more volatile countries might not be able to pay you back. To compensate for this risk, you’ll often receive a higher rate of interest for these bonds.
Grading risk levels
Just like people have a credit rating, allowing companies to decide if they want to offer us loans or mortgages etc, there’s a similar system for bonds to identify which are safest and which are more risky. They’re normally graded according to the government’s or company’s creditworthiness, which ultimately gives us an indication of their ability to pay interest and to repay bondholders at the redemption date.
Government bonds tend to be AAA or AA rated as they're considered higher quality, and therefore a safer option than corporate bonds. But remember that some countries and their governments are considered safer than others. Bonds with a rating of BBB or above are considered to be investment grade, while those with a rating below this are considered to be high yield.
How to invest in bonds
While you can invest directly into bonds, it’s not the simplest thing to do, and it can be a risky strategy to have all your money in one government or company. Because of that many people choose to invest through funds. That way your money is pooled with other investors’ money to buy a range of bonds. You can also choose funds which include a range of investments, not just bonds.
And there’s the added benefit of having an experienced fund manager invest and manage your money for you.
> Find out more about why it's a good idea to have a diversified range of investments.
Read on if you’d like to find out more about bonds.
Fixed isn’t always fixed
If you buy a bond at the time it’s issued, you’ll pay a fixed price for it. But after this bonds trade at the current market price, meaning their prices will fluctuate depending on the following factors:
1. Interest rates
Typically, when interest rates are low, bond prices are high, and vice versa. However, different types of bonds are more sensitive to interest rate movements than others – this is known as a bond’s duration.
Duration is expressed in years, and basically the higher the duration, the more sharply a bond’s price is likely to rise and fall when interest rates change. As such, it can be a useful indicator of how risky a bond is.
When you buy a bond, it usually promises fixed interest payments. So rises in inflation mean that this income won’t be worth as much. As a result, the prices of bonds tend to fall as they’re less attractive. Conversely, if inflation is low, bond interest payments will be worth more, so the prices of bonds tend to rise as they’re more attractive.
3. Supply and demand
A sudden surge in companies or governments that need to borrow can mean there will be plenty of bonds for investors to choose from, so prices are likely to fall. But, if there are more investors wanting to buy than there are bonds on offer, prices are likely to rise.
4. Credit risk
If the credit rating of a bond rises there could be more demand, meaning prices are likely to rise. On the flip side, if the credit rating falls, there will be more sellers - pushing prices down.
What you can yield
Yield is something that’s often mentioned in commentary about bond markets. In the simplest terms, it’s a measure of the income available from buying a bond.
The yield is based on:
- The current price of the bond
- Its regular interest payment (the coupon)
- How long until it reaches its full term (redemption date)
- The type of bond – some bonds pay a flat rate of interest, while others increase interest payments in line with the retail price index (RPI) or another index – so make sure you check
The main thing to remember is that a bond’s price is inversely related to its yield – meaning if the price goes up, the yield goes down, and vice versa.
In relation to bonds, liquidity simply means that there are enough buyers if you want to sell a bond. When the market becomes illiquid, it indicates that there’s a lack of buyers or, in other words, that if you want to sell, you may not be able to. As with any type of investment, a lack of buyers means that if you need to sell, you may have to do so at much lower than market value. The sign of an illiquid bond market tends to be when the gap between the prices at which bonds are bought and sold widens.
This information is to help you understand more about bonds, how they work and why you might want to invest in them. Please remember though that the information here shouldn’t be regarded as financial advice. The value of any investment can go down as well as up and may be worth less than was paid in.