Investing Basics: About Bonds
Bonds are effectively “IOUs” issued by governments, companies or other organisations wishing to raise money to fund growth or restructure their debt and bought by investors such as banks, insurance companies, fund managers and individual investors who receive interest payments in return for the loan of their cash – writes Christian Leeming
- The ‘issuer’ is the body borrowing the money.
- The ‘coupon’ is the rate of interest the issuer promises to pay the lender.
- The ‘maturity’ is the date at which the borrower repays the lender in full.
An issuer wanting to borrow £100 million will issue £100 million-worth of bonds at ‘par’ or 100p in the pound. The coupon is set at the point of issue and the agreed percentage is paid annually or semi-annually for the duration of the loan.
At the end of the term, each bond is redeemed at “par” – 100p – and prices quoted in the secondary market are relative to that starting, and finishing, value.
The majority of bonds issued are ‘senior debt’, meaning that the holder has a claim on a company’s assets ahead of its shareholders.
‘the holder has a claim on a company’s assets ahead of its shareholders’
Bonds have a launch in the same way that there is an initial public offering (IPO) when a company floats on the Stock Exchange; this is the ‘primary’ market when bonds and gilts are sold to investors via an investment bank or broker.
Unlike equities which trade through an exchange, bonds in issue are then traded between one institution and another – for example an investment bank and a broker.
The global market in bonds is enormous – almost double the world’s combined stock market valuation – with wide variety in terms of currency, coupon, duration and a range of other factors.
As a rule of thumb the size of the coupon indicates the level of risk attached to a particular loan – i.e. the risk that the borrower will not replay the loan; the ratings available help to navigate and understand this risk – ranging from Gilts to junk bonds. The DIY investor would do well not to stray from the safer spectrum of ‘investment grade’ bonds.
Bond Types at a Glance
Gilts – bonds issued by the UK government bonds to finance public spending. Rated as AAA, Gilts are effectively considered a risk-free investment. Prices vary from day-to-day depending on the outlook for interest rates but those that buy at par or below, and hold the bonds to maturity will be sure that interest payments will be made and the loan will be repaid in full.
‘Gilts are effectively considered a risk-free investment’
The duration of Gilts vary but the most popular among private investors are maturities between two and ten years; some products have ‘calls’, which enables the government to repay the debt early if conditions are favourable.
Index Linked Gilts – rather than paying a fixed coupon and amount on redemption, payments are linked to the UK Retail Prices Index (RPI) which can be a useful hedge in times of significant inflation.
Perpetual Gilts – have no set maturity date and may be repaid when the government chooses. Prices are more volatile because perpetual Gilts do not have the inexorable journey to maturity and the investor depends upon the market to recoup his funds.
Corporate Bonds – issued by a variety of different lenders, not just ‘corporates’, ranging from foreign governments to medium-sized companies.
As with Gilts, corporate bond prices reflect the market’s expectations for interest rates, but are also influenced by the perceived creditworthiness of the issuer; negative sentiment around a company or organisation, and therefore the increased chance that it may default will see the price of the bond fall.
The value of a bond relative to Gilt can be calculated by comparing the difference in yield offered by a bond over a Gilt of the same maturity.
Floating Rate Notes – bonds where the coupon is not fixed but is based on a rate such as LIBOR; they are typically issued with maturities of between two and ten years.
Convertibles – or ‘Equity Convertible Bonds’ give the holder the right to convert redemption proceeds into the equity in the issuing company; convertible bonds can deliver a combination of yield and growth and their price can be driven higher by a rise in the company’s equity.
Subordinated Bonds – give the holder a lower claim on the company’s assets than traditional bonds, although still above equity holders, in return for a higher yield. Subs are more volatile and sensitive to shifts in the perceived credit quality of the issuer.