A bond is a fixed-term loan that can be traded between investors
Bonds can be issued by governments and companies. ‘Gilts’ is a nickname for UK government bonds, US government bonds are often called ‘Treasuries’, while German government bonds are often referred to as ‘bunds’. They are all bonds, though, and all work the same way.
Unlike the loan you might take out to buy a car or mortgage on your house, these aren’t negotiated with a specific lender. Instead, the issuer lets it be known that they want to issue a bond of a certain amount, along with how long they want to borrow money and the interest rate, and investors are invited to take part.
Once they’ve accepted the bond – and given the bond issuer the principal – the bondholder can keep the bond until the end of the term – when the principal is returned – or sell it on to another investor before that time.
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Bonds typically have a lower but more reliable return than equities
Bonds are less unpredictable than shares: the return profile of a bond is more or less set when it is issued and in tough times bond issuers will prioritise paying bond coupons over issuing dividends for members. Bond prices tend to fluctuate less than share prices, and there is a smaller chance of big losses for bond investors than for investors in shares. Conversely, there is also less opportunity to make big gains.
When investors are thinking about buying and selling bonds, things they will consider include:
Interest rate risk: Are central bank interest rates rising or falling?
If investors think rates will rise, then bond prices tend to fall in value as new bonds coming to the market will offer higher coupons, reflecting the higher rate. When interest rates fall the reverse is true.
Duration risk: How long until the bond matures?
Bonds with longer maturities are considered riskier, as long-term rate movements are unpredictable. Additionally, inflation will have an impact on the principal - £100m pounds today will be worth more than £100m in 25 years’ time.
Credit risk: Will the issuer pay what they owe?
Big, well-established issuers are seen as more reliable than smaller, less well-known bond issuers. Developed government bonds – issuers such as the UK, the US, the major European economies or Japan – are seen as most reliable of all. Bond rating agencies are independent research companies that give bonds a label depending on how likely they think they are to pay, and these ratings help investors decide what they should pay for a bond.
‘Bond yields’ are how investors talk about bond prices
Rather than talking about prices, bond investors typically talk about rising or falling yields. The yield represents the return an investor gets on a bond, taking into account the coupon, the principal and how much an investor paid to invest.
The more an investor pays for a bond, the lower the yield will be. So, if bond prices are rising, this will be expressed in investment commentaries as falling yields; conversely if bond prices fall then commentaries will talk about yields rising. This can feel a bit topsy-turvy: falling yields are good news for bond investors – the value of their portfolio is rising; rising yields are bad news, as the value of the bonds they hold is falling.
Investing in bonds
Individual investors are less likely to be investors in bonds. They tend to sell for millions of pounds or more, making them out of reach for most individuals.
However, bonds can be packaged into a bond mutual fund where an experienced fund manager will pick and choose bonds to hold on behalf of investors.
Over the long haul, bonds are riskier than cash savings but less so than equities and so they tend to have lower returns compared to stocks. However, as is the general rule of thumb when it comes to investments the greater the return on offer, the bigger the risk involved.
Helpful information to help you understand your investments.