Considered by many to be a vital element in any financial plan, bonds can be used to help you grow your wealth.
In this bonds guide we take a look at financial bonds: explaining how bonds work; the vital factors you should consider before making bonds investments; and strategies to consider when making bond investments.
Bonds Explained: What is a bond?
A bond is effectively an “IOU” that is issued by a company or government in an effort to raise capital. The idea is that an investor will buy the debt and in return the issuer of the bond makes a promise to pay a set level of interest every year: plus returning the capital at an established date in the future.
With a bond, a fixed amount is paid out: and there are two main types of bonds to choose from – gilts and corporate bonds.
– Gilts: These are government bonds that are usually considered safer than corporate bonds as a government is usually less likely to default on debt or go bust. They are available as short- or long-term investments: indeed you could even find gilts with terms of 50 years.
– Corporate bonds: More speculative than gilts, corporate bonds are usually considered less risky than equities. Should a company go out of business or default on a debt then there is a risk that the investor will lose their money – however, corporate bondholders are also more likely to get a payout compared to shareholders.
Bonds Explained: How are bonds rated?
Bonds receive grades based on their credit risk: if they are rated AAA-BB then they are considered investment-grade bonds and are usually issued by large companies and governments. Meanwhile, those rated from BB-D are considered high yield bonds (also known as junk bonds), which typically pay a high level of interest.
It is possible for bond prices to vary: with investors needing to pay close attention to yields, which indicate the interest payable, expressed as an overall percentage of the price of the bond. So if you have a corporate bond valued at £1,000 paying five per cent interest over five years the yield would be five per cent. However, should the bond’s value drop to £900 then the yield would rise to 5.6 per cent.
Perhaps of significant importance is that bonds do not have any major association with stocks: meaning that in the event that equities sink, bond values will not necessarily be affected.
Bonds Explained: How to invest in bonds
There are several possibilities when it comes to investing in bonds, including:
– Buying individual corporate bonds: This can be done using a stockbroker or, in some cases, you may be able to buy directly from the company. This is, however, considered to be a risky strategy because if the bond’s value were to drop or the company were to default on an interest payment then the investment will be rocked.
Generally, this strategy was beyond most private investors: however, this changed when the Order Book for Retail Bonds was launched on the London Stock Exchange in 2011. From 2012 onwards, several companies have offered retail bonds with low investment requirements: this was done in an effort to find private investors, including ISA investors.
– Dedicated bond funds: This is often a more diverse way for first-time investors to access bonds. Here it is very important to employ the services of a bond manager who can guide you on when to buy a bond. There are different types of bond funds available including those focused on high yield bonds; investment grade bonds and a combination of the two.
Bonds Explained: Key bond features
There are some key terms that are important to understand before investing in bonds. These include:
– Principal: Refers to the amount on which an issuer will pay interest. Usually this must be repaid at the end of the term.
– Maturity: An issuer has to pay a certain amount on a maturity date. If all due payments have been made then the issuer will have no additional obligations. The time until a maturity date is known as a term. Maturities can be any length of time: most bonds have a term up to 30 years.
– Coupon: This is the interest rate that an issuer will pay to the holder – it is usually fixed for the bond’s tenure.
– Yield: This is the rate of return picked up from a bond investment. It can refer to: the current/running yield, the annual interest payment divided by the existing market price; or the yield to maturity, which considers the market price and the timing of remaining payments.
– Credit quality: This reflects the probability that bondholders will receive the promised amounts on the due dates. This depends on a number of factors.
– Market price: Prices of tradable bonds can be influenced by a number of factors, including: currency, timing and the level of interest payments. Prices can be either “dirty” or “clean”. Dirty focuses on the present value of future cash flows with accrued interest included; whereas clean does not include this accrued interest. Generally, dirty is used in Europe and clean in the USA.
Bonds Explained: What to consider
Before you invest in bonds think first about why corporate bonds are right for you. For example, are you looking for them to add income flow; for a return with low risk; or are you looking to diversify your investment portfolio?
Corporate bonds are often a good feature of a diversified portfolio, particularly among cautious investors. However, they do carry the risk of capital loss so they are not a direct replacement for cash. As such, cautious investors should be careful not to hold too many bonds.
PLEASE NOTE: This article is meant to be a general guide to bonds. It is not to be constituted as financial advice. If you are considering investing in bonds seek independent financial advice first.