Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
When it comes to the asset class work Christmas party, bonds tend to be overshadowed by their flashier, better-looking equity colleagues. Bonds are far more comfortable crunching numbers than they are cutting shapes. And while equities like to think of themselves as the life and soul, a company’s success doesn’t always rest on the employees who shout the loudest. Often, it’s the quieter, more studious among us who do the heaviest lifting.
The $100 trillion bond market is by far the largest of all securities, yet it’s one that many investors avoid due to its perceived complexity when compared to equities. In this article, I’ll be covering all the essentials you need to know so that you can feel comfortable with bonds: what they are, why you should be interested, and how you can invest in them.
1 - What?
A bond is a loan made between a lender who purchases the bond, and a borrower who issues it - typically a company or government that needs the loan to finance their own growth or to fund development projects. When issuing a bond, the borrower will stipulate three things:
• The ‘face value’ price of the bond
• An annual interest rate, known as its ‘coupon’, and
• A ‘maturity date’ when the borrower will repay the face value to the lender.
Say company ABC wants to raise £100,000. ABC may issue 1,000 bonds at a face value of £100 each, with a coupon of 5% and a maturity date of 10 years. Any investor who buys one bond would expect to pay £100 and then receive an annual payment of £5 each year for 10 years, until the bond reaches its maturity, at which point they would be repaid their initial £100 outlay.
Easy, right - put your money in, get a ‘fixed income’ out. Well, there’s a bit more to it. Consider, for instance, what happens if the company issuing your bond collapses. Suddenly that income isn’t looking quite as ‘fixed’ as before.
To compensate for the increased risk of collapse, bonds issued by companies which seem less stable will usually offer higher interest payments. As ever, greater risk can lead to better returns.
Getting this balance right is important, so big credit rating agencies like Moody’s and S&P assess companies and governments’ stability, designating bonds from riskier issuers ‘high yield’ or ‘junk’ bonds, and safer bonds ‘investment grade’.
2 - Why?
Bonds have traditionally been a good asset to hold alongside equities for diversification purposes. They’re lower down the risk scale than individual shares and generally act differently, giving your portfolio the chance to have at least some cylinders firing at any one time.
They’re also a good source of regular income. With expectations of reliable income streams from equities severed by recent cuts to companies’ dividends, regular coupon payments can provide comfort to income-hungry investors.
Finally, there’s real opportunity for capital growth. Once bonds are issued, they can be traded ‘over the counter’ on the open market. Depending on market sentiment towards the bond, it may trade above or below its face value. Think of this like shares traded on an exchange - after an initial share release, their value similarly will rise and fall in line with customer demand.
3 - How?
There’s a long and a short answer to this one. Let’s start with the short one.
There are countless bond funds with managers who are willing to do all the hard work for you. It’s important you find the right fund to meet your objectives. Typically, bond funds will vary in risk allowance and income vs capital growth priorities.
Our Select 50 features a number of bond funds, and you can find an overview of all of them here. We also feature regular individual fund insights and manager interviews on our recently revamped Markets & Insights hub page.
That, essentially, is all you need to know to get started. But it pays to look a bit closer and discover how you can find the best opportunities.
For bond investors, most of the action happens on the open market. There, people don’t care about a bond’s face value - what they’re willing to pay depends largely on how the bond’s interest payments compare with prevailing interest rates.
When interest rates are low, investors turn to bonds which consequently offer better levels of fixed income. This pushes bond prices up and yields down, with the difference between the bond’s price and its returns decreased.
Clearly, low yields aren’t great for investors. But play your cards right, and low interest rates can become your friend.
Say you bought a newly issued bond at face value £100 with 2% interest. The next day, the Bank of England drops interest rates from 3% to 1%. Suddenly, your 2% bond looks a lot more appealing against the 1% return you’d get elsewhere. Investors are now willing to pay up for your bond, and so you sell it for £105, making a £5 profit. Not bad for a day’s work.
Changes in interest rates, then, can be good and bad for bond investors. One thing they will look at to help assess these risks is a bond’s ‘duration’. Duration gives you a sense of how a bond’s price will react to changes in interest rates. The higher a bond’s duration, the greater its volatility - the more its value would rise were interest rates to fall, and the more its value would fall were they to rise.
Bonds, then, though complicated souls, really do have a lot to offer. At this year’s Christmas party, why not strike up a conversation with one.
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Select 50 is not a personal recommendation to buy or sell a fund.This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
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