One of the most common financial instruments, a bond is a debt investment. Although complex vehicles, bonds are popular with investors wanting regular income. Here, we explain how bonds work and outline how you could invest in the asset class.
A bond is a loan from an investor to a government or company, typically. This is used to pay bills, raise cash and make new investments.
When you buy a bond, you expect the loan to be repaid in full at a predetermined date (maturity). Investors also expect to earn a periodic income throughout the life of the bond as interest (coupon payments) for lending their money.
Arguably the most crucial cog in the global financial market, the bond market is worth over $50 trillion. This makes it larger than the stock market.
How bonds work
To understand the characteristics and return of a bond investment, let’s look at a simple example.
Say you want to buy a government bond for £100 with a maturity of 10 years, paying a 2% regular coupon. This is what your cash flows will look like:
- You pay the government £100 for the bond – this is its face value
- Each year you will get £2 in interest for holding the bond
- After 10 years, you will get your principal £100 back
At maturity you will have £120 from the bond; the £100 you originally lent and £20 profit from the interest payments.
You’ll hear yield mentioned a lot in relation to bonds; this is just another way of saying the income return and is usually expressed as a percentage of the price. Yields have an inverse relationship with the price of a bond. As bond prices fall, yields will rise, and vice versa.
When investors look for riskier investments like equities, yields traditionally rise. Yields could fall when sentiment swings and there’s demand for safer investments. This could be the result of high unemployment figures or weak economic growth.
What is the yield?
There are a number of different bond yields to calculate, including the nominal yield and current yield.
Nominal yield calculates the coupon rate of the bond divided by its face value, although it doesn’t always represent the overall value.
The current yield divides the annual cash inflows by the bond’s face value to reflect the return an investor can expect over one year.
The yield to maturity is calculated to measure the total return on a bond when it is bought, assuming it is held to maturity. It’s a very complex calculation that can help investors compare bond value.
The advantages of bonds
Providing governments and companies with cheaper financing options, bonds are also extremely popular amongst investors.
Thanks to their repayment and regular income, bonds are traditionally seen a safe haven. With the right research, you can build a diverse portfolio of bonds designed to help you reach your financial goals.
The disadvantages of bonds
Although bonds are seen as a safe haven, it would of course be wrong to label them as risk free, and there are risks to investing in bonds.
Investors have to consider a bond’s credit risk, which is the risk of a default on a bond payments. Indicating the financial strength of the issuer, and ability to repay the principal value or the bond and interest, governments and companies are given an investment grade by credit ratings agencies. This rating influences the yield and price of a bond.
The reliable reputation of bonds have been tarnished in the past. After years of economic hardship following the financial crisis, Greece, in the middle of a sovereign debt crisis, defaulted on its bond payments in 2012. And during the financial crisis, Britain was seen as more likely to default on its bond than McDonalds¹.
You might also be missing out on potential returns by not taking on the right amount of risk with your investments for your investor profile. Whilst bonds are great for providing you with regular income, your scope for return is limited and may not be able to keep up with inflation.
All investments carry risk; it’s about balancing risk and reward to generate the returns you need to reach your goals.
Things to consider when investing in bonds
Bonds and interest rates
Whilst bonds can be held to maturity, you can also buy and sell them during their financial lives. As conditions change, the price of the bond and the interest rate attached to it will fluctuate to reflect market sentiment.
Bonds are exposed to any interest rate movement as any central bank rate hike will encourage investors to look for higher interest.
Put simply, if your bond pays interest of 2%, but interest rates rise to 6%, you will want to own bonds with higher coupon rates instead. With little demand but plenty of supply, the price will fall. The opposite is true when interest rates fall.
How much time you have
The first step to reaching your financial goals is understanding your investor profile, time horizon and attitude to risk.
This should influence how and what you invest in, helping shape the portfolio that will take you a step closer to reaching your financial goals.
If you’ve got a short time horizon and want to protect the value of your money over growing it for the future, you might prefer to increase your exposure to bonds in your portfolio.
You’ll have to accept a limited scope for return, but the value of your money should be protected. Diversification of the bonds in your portfolio can help your money work in the best way for your goals, allowing you to take advantage of market trends.
Your level or risk
But if you’re investing for the long-term and can afford to take on more risk, you could make your money work harder for you in riskier assets like equities.
The more risk you take with your money, the more return you can expect – although the further your investments can also fall. This is because your investments will have the time to recover from any short-term fluctuations and benefit from long-term growth trends.
How to invest in a bond
Finding the right balance between risk and return can be complex, and keeping on top of the financial chatter to predict any movement in interest rates can be time consuming.
As an asset class, bonds are the basic building blocks to any investment portfolio. If used correctly, can help an investor achieve their financial goals. But it can be tough integrating bonds into a diversified portfolio, ensuring they complement the dynamics of your other investments.
Exchange traded funds are popular with investors wanting low-cost, flexible and diversified fixed income exposure in their portfolio.
The different type of bonds
There are a number of different bond types available to investors. Each have different characteristics that perform important roles within a diversified portfolio. These include:
- Government bonds – gilts and Treasuries
- Corporate bonds – high yield and junk
- Municipal bonds,
- Inflation-linked bonds
- Convertible bonds
- Callable/Put bonds
Government bonds/ Treasuries
Issued by national governments, Gilts and Treasuries are traditionally seen as ‘safe’ investments. Remember, there’s always a risk to investing.
Countries are given investment ratings just like companies, and those that are more likely to default will likely have to include a higher interest rate payment. This represents as the cost of borrowing for the issuer.
Gilts and Treasuries traditionally have high investment ratings, as governments are able to either increase taxes or print money if they struggled to repay the bond.
Issued by local governments, Municipal bonds can be riskier than traditional Gilts and Treasuries.
Although there’s more risk associated with these instruments, they do carry tax benefits for investors. These tax benefits do reduce the yield, however.
Inflation linked bonds can help protect your money from inflation and are primarily issued by governments like the UK and US. In America, these are called Treasury Inflation Protected Securities, or TIPS.
The bond’s principal value and interest rate are contractually linked to a reliable measure of inflation. This could be the retail price index in the UK and consumer price index in the US.
Inflation-linked bonds can provide a good hedge for investors against rising prices. However, the principle value could fall below the par in a period of disinflation. The coupon could also reduce.
Governments can also issue you a bond that pays no coupon but is offered at a discount. These are known as zero-coupon bonds (Z bonds).
You’ll get all of your profit when the bond matures. As this return is saved entirely until maturity, there is more volatility in the price of Z bonds.
Investment grade corporate bonds
Corporate bonds tend to have higher yields than government ones, and bonds issued from highly-rated corporations are known as investment grade corporate bonds.
Bonds can have fixed or variable interest rates, with different ranges of maturity. Short-term bonds generally have a maturity of five years. Medium-term bonds have a maturity of five – 12 years, with long-term bonds having a maturity of over 12 years.
High yield corporate bonds
High Yield corporate bonds have an investment grade of BB or lower from credit ratings agency Standard & Poor’s, or Ba and below from Moody’s.
Also known as junk bonds, they have a higher default risk compared to investment grade bonds. Investors find them attractive because they traditionally have a higher yield than safer instruments.
Imagine a company issues a ten-year bond, but interest rates start to fall over this period.
They’ll probably want to redeem their bonds to reissue it with a lower coupon. This is possible with callable bonds, which tend to have higher yields than normal bonds.
Where a callable bond allows the issuer to recall a bond, a put bond allows the investor to force the issuer to repurchase the bond before maturity. As the issuer will have an obligation to repurchase before maturity, putable bonds have lower yields.
A convertible bond allows you to exchange your bond for a predetermined amount of equity during the bonds life.
This gives investors the opportunity to protect their principal investment in case of negative events, but also benefit from positive momentum.