Investing Basics: What are Bonds?
Bonds can be a valuable element of the DIY investor’s portfolio, delivering guaranteed income over a set period of time and the return of the invested capital in full at a pre-determined date.
City speak would have it that bonds are ‘debt securities issued by governments, companies and other organisations in order to raise capital’.
Well that they are – but put simply bonds are loans; the issuer of the bonds is the borrower (debtor), the holder of the bonds is the lender (creditor) and the coupon is the interest paid to the holder for lending the money (usually paid annually or semi-annually).
The maturity of the bond is the date at which the original loan is returned in full to the lender in every eventuality other than default.
As with any investment the magnitude of the return (coupon) reflects the perceived danger that the borrower will fail to pay back the loan.
‘Sovereign debt’ has crept into the general lexicon since the various troubles that Greece, Portugal, Spain and Ireland in particular have encountered since 2009, but generally sovereign debt should be the safest around as it is guaranteed by the economy of an entire country.
However, as the economy of a country is called into question, the price it has to pay to borrow money increases – a reward to the lender for taking the extra risk, but a drag on a country struggling to balance the books.
Types of Bonds
There are various types of bonds:
These are bonds issued by the UK government to finance public spending. UK gilts are currently given the highest credit rating by all major credit rating agencies and are virtually risk-free, i.e. the likelihood of the UK to default on its debit is almost non-existent.
Gilts are denoted by their coupon rate and maturity year, e.g. 4¼% Treasury Gilt 2055.
The coupon paid on the gilt typically reflects the market rate of interest at the time of issue of the gilt, and indicates the cash payment per £100 that the holder will receive each year in two payments.
The first fund raising that could be considered a gilt issue was in 1694 when King William III borrowed £1.2m to fund a war with France via the newly created Bank of England.
Around two-thirds of UK Gilts are held by insurance companies and pension funds.
Unlike conventional gilts where the interest payment and redemption value are fixed, the interest payment for index-linked gilts is adjusted each year in line with inflation.
The redemption value of the gilt will also be adjusted for inflation when the gilt matures.
These are issued by companies and other organisations to raise money to finance investments.
Corporate bonds have traditionally been bought by large institutional investors although they started to be offered in small denominations o retail investors when the London Stock Exchanged launched its Order Book for Retail Bonds in 2010.
Investors can now buy into these issues for as little as £2,000.
What are the advantages of bonds?
UK government bonds are one of the safest investments as the risk of the UK government being unable to repay its debt is very low; government bonds should be considered superior in credit quality to a bank deposit.
Multi-national government agencies such as the World Bank also offer extremely safe investments.
For corporate bonds, there is of course the risk that a company may go bankrupt, but in the event of bankruptcy, bondholders are ranked above shareholders in their claim on the company’s assets.
Return of capital
When you buy an equity your return is dependent upon your ability to sell the shares back into the market; with a bond, you know from the start that if you hold the bond to maturity, you will get your investment back.
Bonds usually generate a higher income than equities.
‘Bonds usually generate a higher income than equities.’
Unlike dividends from equities, whose value can fluctuate or who can be withheld completely, with a bond the investor knows from the start the value of future income payments.
With an ageing population, income becomes an increasingly valuable aspect for any portfolio and bonds may be ideal for investors who wish to secure future income over a defined period of time.
With bonds paying annually, semi-annually or sometimes quarterly, a carefully chosen bond portfolio with six or more holding can produce a reliable monthly income.
Bonds can be used to diversify a portfolio. Investing in only one asset class increases the risk in a portfolio and spreading one’s investments over several asset classes will help reduce the risk.
Bond funds bring the additional diversification of investing in a basket of bonds, although with the attendant management charge.
In certain economic scenarios, such as a recession, bonds will generally show an inverse correlation in price movements to equities.
If a bond has at least five years to maturity when the initial investment is made, it can be held in a shares ISA or SIPP, thus ensuring any gross interest from the bond will be paid tax-free. Most bonds also attract no capital gains tax and are exempt from stamp duty.
Benefit from falling interest rates
When an investor buys a bond, the interest rate is fixed until maturity of the bond. If, later on, interest rates fall, the market value of the bond will rise.
Investors will therefore benefit both from a secure income and capital appreciation of their asset.
What are the risks?
The risk that the issuer of the bond may be unable to repay the loan.
The price of a bond may fluctuate from day to day according the balance of supply and demand in the market. As long as the bond does not need to be sold, this will only create a paper gain or loss. However, if a bond needs to be sold to raise funds while the price is low, the investor may lose some of the initially invested capital.
Many bonds are issued with imbedded features such as “calls”, which enable the issuer to repay the debt ahead of schedule. The holder might thus lose out on interest payments.
As such features are clearly described in the bond prospectus before the bond is sold, investors can avoid such bonds or make contingency plans.
Unforeseen events may have a negative impact on the security of the bond. The government may change the tax rules or a technological invention by a competitor may make the bond issuer’s products obsolete. Inflation is also a risk as it will decrease the value of the bond over time.
A bond’s credit rating
The credit rating given to a bond reflects the issuer’s ability to service and repay the debt. The higher a bond’s credit rating, the higher the
‘Bonds rated below BBB are known as ‘non-investment grade’; they can also be known as ‘high yield bonds’ or ‘junk bonds’ – you pays your money and takes your choice.’
likelihood that investors will have their capital returned and receive an income from the bond.
There are two main international credit rating agencies, Moody’s and Standard & Poor’s, that assess the credit rating of government and corporate bonds. Ratings rank from the highest AAA, where the issuer is extremely likely to meet its financial commitments to D, where the issuer is in default. Standard & Poor’s credit ratings are as follows:
AAA – extremely strong capacity to meet financial commitments. This is S&P’s highest rating.
AA – very strong capacity to meet financial commitments.
A – strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.
BBB – adequate capacity to meet financial commitments, but more subject to adverse economic conditions.
BBB- – considered lowest investment grade by market participants.
BB+ – considered highest speculative grade by market participants.
BB – less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.
B – more vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.
CCC – currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.
CC – currently highly vulnerable.
C – currently highly vulnerable obligations and other defined circumstances.
D – payment default on financial commitments.
Bonds rated between AAA and BBB are “investment-grade debt”.
Investors managing portfolios where the risk must be minimised, and security of income and capital is paramount, will restrict themselves to bonds rated AAA and AA, with perhaps a few single A investments.
Bonds rated below BBB are known as ‘non-investment grade’. These bonds are of a more speculative nature, and imply a certain degree of risk; they can also be known as ‘high yield bonds’ or ‘junk bonds’ – you pays your money and takes your choice.