Bonds, sometimes known as fixed income or fixed income securities, are a form of IOU. You lend money to a company or government, and it pays you a fixed return – sometimes called a coupon – for doing so.
At the end of the bond’s term, when it matures, you get back the original amount you paid for the bond. The duration – as it’s known – can be from three months to as much as 50 years.
Interest rates influence the way bonds are priced. When interest rates increase, bond prices generally tend to go down. When interest rates fall, bond prices rise.
Benefits of investing in bonds
A key reason for investing in bonds is to receive an income. All types of bonds provide investors with a pre-determined interest rate, which for income-seekers, particularly those in retirement, is a tempting offer.
Diversification is another key benefit. Bonds can provide a safer alternative during times of market uncertainty as they traditionally behave differently to stock markets. Held alongside equities they can help to reduce the volatility of the portfolio as a whole, as bond prices typically fluctuate less.
Since returns are already fixed – unlike the capital returns and dividends issued to shareholders, which can change – they are popular with more cautious investors who don’t like the idea of the value of their money rising and falling.
Some investors, particularly those reaching retirement, may want some bonds for reliable income and diversification away from the stock market, property or more basic savings accounts.
Types of bonds
There are a whole host of different types of bonds offering different levels of return – and risk.
Government bonds
Bonds issued by the UK Government are also known as gilts. The name refers to a time when they were issued in the form of paper certificates with gilded edges.
There are tax benefits when it comes to holding gilts. Any profit made from a gilt when you sell or redeem it is free from capital gains tax, unlike many other investments, such as shares, funds or investment trusts held outside an Isa.
It’s particularly advantageous for higher and additional rate taxpayers who would otherwise pay capital gains tax at 20pc.
Governments in other developed countries issue bonds too, such as the US.
Emerging market bonds are issued by countries or companies in the developing world. Emerging market debt carries more risk as there’s a greater chance of defaulting and it can be volatile owing to currency movements – but there are clear opportunities.
The liquidity and the financial strength of bond issuers, as well as political stability, need to be considered when assessing these government bonds.
The coupons on emerging market debt can be very attractive, often in double figures.
Corporate bonds
Corporate bonds allow you to invest in big companies in a less risky way than buying shares in them. Corporations will often issue bonds to allow them to fund growing their business, perhaps by buying property and equipment, or hiring more staff.
Corporate bonds come in many guises within this sector. Those from companies with high credit ratings (which are an indication of a financial strength) are known as investment-grade bonds. Companies with a higher level of risk associated with them are known as high yield or sometimes as junk bonds.
Investment-grade corporate bonds are issued by companies which ordinary investors are likely to have heard of, such as Apple and Tesco.
Should a business run into financial trouble, these bonds rank higher in the pecking order than shareholders, so you can take comfort from that when it comes to weighing up risk.
High-yield or “junk” bonds are issued by companies with lower credit ratings. To compensate for the greater risk taken by investors that they might default on a payment or not be able to repay bondholders in full, these bonds pay higher returns. High-yield issuers are often smaller companies in more niche, specialist areas.
Inflation-linked bonds
A specialist sector of inflation-linked bonds – also known as index-linked or “linkers” – pay interest that rises with inflation. Such bonds aim to offer protection when stock markets fall, as well as providing a shield against inflation.
Bond returns
A bond’s yield is expressed as a percentage. It’s the return an investor can expect to receive as income over the next 12 months, which is based on the amount originally invested.
When it comes to prospects for returns ahead, there’s no crystal ball to tell investors what to expect.
Hal Cook, a senior investment analyst at Hargreaves Lansdown, believes that interest rates are likely to be at their peak for this cycle, with the broad expectation being that rates will come down from here.
He said: “This is good for bonds, because falling yields means increasing prices. Current market pricing is suggesting that interest rates in the UK will be around 3.25pc to 3.5pc in five years’ time. This figure is around 3.6pc for US interest rates and 2pc to 2.25pc for Europe. If this turns out to be correct, that will mean interest rate cuts from three of the most influential central banks globally in the coming months and years.
“When inflation falls and the central banks cut rates, bonds appeal more to investors. This increases demand and pushes the price up – so investors who are holding bonds will see the value of their holding increase.
“In the event of a market shock, it is possible that bonds will increase in value again. This is particularly true for government bonds such as gilts, that could benefit from a safe haven trade in a market-shock environment.
“The potential for bonds to increase in value in this scenario increases their diversification benefit within an investment portfolio.”
Risks of buying bonds
One major risk to fixed income is that posed by inflation. Bonds are less attractive in periods of rising inflation because as prices rise, the value of the income in real terms is reduced.
While inflation is today rising at a much slower pace than in previous years, it’s still high.
The lower volatility of bonds also tends to make them popular with cautious investors or those who want to reduce overall risk in a portfolio, but there are no guarantees as bonds can experience rough times too.
Credit risk is another issue for bonds. This is the risk of a company or government defaulting by not paying the coupon or repaying your capital.
Liquidity is a risk because if you want to sell and can’t find a buyer you cannot cash in your investment.
For global bonds, where bonds are paid and priced in local currencies, there is currency risk because the value of that currency could fall, impacting the value of your investment.
Bonds with a shorter lifespan of five years or fewer can be considered less risky as there is not as much time for things to change in terms of the economic environment. That’s why a lower level of income is typically offered with short-duration bonds. Those with a longer duration usually pay a higher level of income to compensate for the greater levels of risk involved.
It provides a trading service, meaning that you can buy and sell gilts that are already in the market. However, to be eligible to use the service you must first sign up as a member of a DMO “approved group of investors”, which is only available to UK residents.
You don’t need to be a member of the approved group to sell gilts via the service, however. For buying or selling, you’ll pay fees of 0.7pc of the value of the gilts you’re trading.
Alternatively you can use a stockbroker or investment platform, such as Hargreaves Lansdown or Interactive Investor. Each gilt is priced differently and will be constantly changing, and will have varying coupon and maturity dates, which means that there are several choices to make before investing.
The maturity date and the coupon appear in the name of the gilt, so they are easily found.
You can also buy corporate bonds via an investment platform.
Emerging market bonds are not so readily available. You can get exposure by investing in a global bond fund which would usually hold emerging market debt.
In fact you can buy all types of bonds in an investment fund where you’ll pool your money with other investors to hold a portfolio of bonds. These funds are either run by a fund manager or invested via a tracker fund or an exchange-traded fund (ETF) which will mimic an index of bonds.
Some fixed interest funds allow ordinary investors access to all types of bonds in one fund. Strategic bond funds are run by a manager who is permitted to move between the different types, according to where they see the greatest value.
Bond funds are available to buy on investment platforms and can be held in tax-efficient investments such as an Isa or self-invested personal pension.
