Learn About Investing

Learn About Investing

Learn about

Bonds

This is an article about bonds and how they relate to investing in general, not Orbis Access in particular.

Learn About Investing bonds

Some savings accounts and Cash ISAs are described as ‘fixed rate bonds’. Your cash is tied up for a fixed time (usually between 1 and 5 years) and, in return for this lack of flexibility, they may offer preferential rates of interest. You may also be aware of premium bonds.

Neither is the type of bond being outlined here. This article takes a look at a class of financial asset called bonds. These are essentially glorified I-O-U notes, but they can go down in value as well as up, so it’s not the same as holding cash.

If you need to borrow money you might go to a bank and ask for a loan. But if you happen to be a large corporation, or a government, you may have other options and it could just be the bank isn’t big enough. That’s where bonds come in.

Imagine you’re a big energy company wanting to build a dam, which you anticipate will generate lots of electricity and profit in future. To help fund this venture, though, you need to raise £1bn. One way to do this would be to issue bonds.

Let’s say 10 million bonds are created, each with a face value of £100. The company promises to pay the bond-holder £100 on a given date in future, when the bond ‘matures’.

In the meantime, regular payments (often twice a year) are made to the bond-holder in return for stumping up the cash. These fixed pay-outs are known as the coupon. It also explains why bonds are referred to as a type of fixed income investment, with predictable returns.

The yield, expressed as a percentage, is a critical measure for bonds. It’s equivalent to the interest rate of a savings account or, more generally, the rate of return on your investment. For example, a bond costing £100 with two £3 coupon payments every year, would amount to a 6% annual yield.

So, bonds are a form of debt and if you buy a bond from a company, you become a creditor. This is different from buying shares in the same company, which would make you a part-owner. Companies are not obliged to pay their shareholders dividends, but bond-holders have legal rights to the promised coupon payments. They are also higher up the pecking order in terms of getting money back if the company should go bust.

Bonds used to be physical pieces of paper, often elaborately printed, and this explains why interest on bonds is called the ‘coupon’. Bonds featured tabs along one edge – coupons – that were cut off to indicate that a scheduled interest payment had been made.

As with cash, some people have been tempted to forge bond certificates. While many such ventures failed, William Brockway, an infamous US counterfeiter in the 19th Century spent most of his life wealthy. The Secret Service agent who chased him died penniless.**

Types of bond

Typically, bonds are issued by governments and big businesses. UK government bonds are called Gilts, while corporate bonds refer to those issued by large companies.

UK government bonds almost always have a £100 face value, but the maturity date can range from just a few months to 50 or even 100 years in the future. The average is about 14 years. Most pay fixed rates, but some are index-linked (meaning the coupon will change relative to the rate of inflation).

In addition to regular corporate bonds, there are more exotic types such as convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem before the date of maturity.

Are bonds for me?

As well as purchasing new bonds, people can trade existing bonds. This means that bonds may find themselves trading at above, or below, their face value during their lifetime.

Compared to other classic investments, high quality bonds are generally recognised at the low end of the risk spectrum: less risky than shares or property, but more risky than cash.

Over the past 113 years, the average real annual return for UK shares was 5.3%. For bonds it was 1.4% and ‘cash’ savings 0.9%.* But be aware, returns may vary greatly from year to year, especially for shares. Nor is past performance a reliable indicator of future results.

Unlike their 007 namesake, bonds have something of a Steady Eddie reputation. Relatively safe but, well, a bit dull. Mind you, when stock markets hit trouble, bonds can have a habit of becoming very fashionable again.

Bonds are an important component of many investment portfolios, with a host of useful applications such as…

  • When it comes to generating predictable regular income, which is of particular note to pensioners
  • When investing over shorter periods – under 5 years – bonds become more attractive because they are less volatile than shares
  • As a defence against the volatility of shares if you’re approaching retirement. You don’t want to be pulling a large pension pot of shares out of the stock market just after a market downturn.

How risky are bonds?

While bonds are broadly less volatile than shares, there are risks, which include…

  • Interest rate risk. The price of existing bonds is hard-wired to interest rates. A combination of logic and maths is behind this relationship, which is explained in more depth here. In the UK, the ‘base rate’ is set by the Bank of England. If interest rates rise, the price of bonds goes down and vice versa. As such, bonds generally depreciate in value in an era of rising interest rates.
  • Inflation risk. Inflation is usually bad news for bonds. If a £100 bond pays out £4 (4%) annually and inflation is 2%, then the inflation-adjusted yield is 2%. But if inflation doubles to 4% the bond is returning no yield in real terms. (This doesn’t apply to index-linked bonds, which adjust their income payments to match inflation).
  • Default risk. Another significant risk is the threat of default. It’s all very well someone saying they’re going to pay you back in a few years, but are they actually going to do it? The US and UK governments have never (so far) failed to pay up. But occasionally other governments have defaulted, such as Argentina in 2001. Companies go out of business on a more regular basis – and that’s obviously bad news if you hold bonds they’ve issued.

It’s important to recognise then that bonds are not automatically ‘safe’. Far from it. There is a very broad spectrum of risk. As ever, the risk vs. return formula applies. This means that the bonds with higher yields may signal greater risk.

UK government bonds are regarded as very safe and thus yield less than those from a government looking less likely to repay its debts. Some corporations are stable businesses and thus likely to be around in a few years when their bonds mature.

But companies with less of a track record, or which seem shaky, could have their bonds labelled with ‘junk’ status. These may yield more income, but the threat of default is correspondingly higher.

To help work out how risky a bond is, ratings agencies check out the companies and governments issuing them. They give each bond a rating, with AAA (the famous ‘triple A’) denoting the lowest risk of all. Bonds with low risk ratings are referred to as ‘investment grade’. But remember, these scores rate only the credit-worthiness of those issuing bonds, not the risks posed by rising interest rates or inflation.

However, the rating agencies aren’t infallible. Infamously, back in 2008 they assessed some mortgage-related bonds as AAA despite the fact they were rotten and anything but low risk. The fallout sparked a global financial crisis.

How to buy and sell bonds

While some bonds can be bought directly from the issuer, in practice you’ll most likely find them in the same place you buy and sell shares.

As with shares, one can invest in funds that hold a diversified basket of bonds. And like shares, bonds may be held in the Stocks & Shares portion of ISAs.

*Source: Dimson, Marsh and Staunton via Credit Suisse Global Investment Returns Yearbook 2014

**Orbis Access does not endorse forgery or careers in the Secret Service.

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