What is a bond?
In essence, bonds are ‘I owe you’ notes issued by governments and companies looking to raise cash. When you invest in a bond, you’re loaning a government or company money for a set period of time – usually a number of years.
When you invest in a bond, in exchange for handing over your cash, you earn a regular fixed rate of interest, known as a ‘coupon’. When the bond’s life comes to an end and it reaches maturity, your original capital should be repaid in full.
The main risk with bond investing is that the issuer could get into financial trouble and find it can’t meet its interest payment obligations, or worse, it goes under and investors lose all of their money as a result.
After they’re initially issued, bonds can trade on the secondary market and swap hands between investors. The price at which they’re bought and sold will generally be determined by two factors – interest rates and how attractive the issuer is, certainly in terms of their solvency.
These bonds are different to savings bonds (which are usually fixed-term bank and building society accounts). Savings bonds are covered by the UK's Financial Services Compensation Scheme (FSCS) but these aren’t. The FSCS currently provides cover of up to £85,000 per person, per institution, in the event that the bank or building society issuing them becomes insolvent.
Corporate and UK government bonds
Corporate and UK government bonds have no such protection. Investors can either invest directly into a bond or via a bond fund, which will hold a wide variety of fixed-income assets to help spread their risk.
Aside from making up part of a diversified portfolio, bonds have a number of attractions. They tend to be, historically at least, far less volatile than shares and offer a steady income stream. They may also suit investors nearing retirement who want to move away from riskier assets like equities, and retirees looking to yield an income from their wealth, but it’s important to understand that, like equities, they too can fall in value.
Gilts and government bonds
In the UK, government bonds are called gilts, in the US government bonds are known as treasury bills, or T-Bills, while German federal bonds are referred to as bunds. In the UK, the government also issues index-linked gilts that pay interest that increases in tandem with the Retail Price Index – to keep in line with inflation.
Gilts are widely viewed as being among the safest type of bond. However, the interest rate, or yield, available from Gilts is usually quite low – as with all investments, to enjoy potentially higher returns, you need to take on more risk. But a loan to a stable government with a strong economy should help to keep your asset allocation reasonably well spread if you already hold other types of investment.
Corporate bonds
Corporate bonds are issued by businesses looking to increase capital, usually to help with things like expanding into a new market, or to develop some area of the firm. While the interest rate offered by corporate bonds will typically be higher than gilts, they come with more risk, given that a company is more likely to default on payments than a government.
Permanent interest-searing shares (PIBS) are a lesser-known type of bond and are issued by building societies. They’re listed on the London Stock Exchange (LSE) and normally have no redemption date. Some have a 'call' date, which means the building society has the option to redeem the PIBS on that date if they wish. The interest payment is usually paid in two equal annual instalments.
Credit ratings
You can get some idea of how safe or reliable a bond is perceived to be by its credit rating. If you plan to buy individual bonds – as opposed to investing via a fund – credit ratings are worth researching at the outset and monitoring over the duration of your investment.
The rule of thumb is the lower the credit rating, the higher the rate of interest offered. But, equally, with a lower credit rating, comes a higher level of risk.
Credit ratings are worked out by specialist credit rating agencies – such as Standard & Poor's and Moody's. The ratings are an assessment of the risk of a company or government not paying back its debt. Investors must take on board that a credit rating (however high) doesn’t guarantee the investment is safe. Some so-called ‘high-yield’ bonds, offer a higher rate of interest but they come with much more risk and are often referred to as ‘junk bonds’.
In terms of ratings, bonds with the most solid appraisal are labelled 'AAA'. Anything from this level down to ‘BBB’ is classified as investment grade and deemed to be lower risk. Bonds given a B and BB rating are classified as 'high yield' and described as speculative, with a high risk of default, while those rated C, CC and CCC, are even riskier.
Those rated D are 'high yield' with a warning that there's a default risk with the bond issuer being unable to pay back debt, in S&P's opinion. This makes it extremely high risk.
Investment risks
Like all investments, bonds come with risks and you could lose money. Beyond the risks posed by the issuer, bonds are very sensitive to where interest rates are and the direction they’re likely to be headed. For example, when interest rates fall, the fixed rate of income or coupon on offer becomes far more appealing and bond prices rise. However, the exact opposite is true when rates rise. Bonds, also suffer during periods of inflation for similar reasons due to the fixed rate of income they provide and vice versa during deflationary periods.
However, bond investors are also more protected when it comes to getting their money back than shareholders in a company. This is down to the fact that were a company to go bust, bondholders have preferential treatment to be paid first before shareholders, who receive only what is left after all creditors have been paid. This doesn't mean that the investment is guaranteed if the company does go into liquidation as there may be no money left to pay bondholders.
