Bonds are effectively IOUs. You lend a company or government money for a set period in return for a fixed income, known as the coupon. This set income means bonds are often called ‘fixed interest’ investments. When the bond matures, you should get your original investment back.
Bonds are not designed to produce capital growth, although they can generate a little, so these investments are not really suitable for investors seeking high returns. But they do provide investors with greater protection than shares as bondholders are above shareholders in the pecking order if the company goes bust.
This gives them great value as ‘safe haven’ investments during economic downturns and the income they pay makes them very attractive to people looking for income from their investments.
How bonds work
What influences bond prices
Different types of bonds
Buying bonds
Very few investors hold bonds until maturity and instead trade them like shares. So, although they have a fixed price when they are issued, demand from investors can push the price above and below this level. This effectively increases or decreases the income you earn.
Bonds are issued in bundles of £100 so if, for example, a company agrees to pay bondholders a set amount of £10, the yield is 10%. If the bond is then traded in the open market and is sold for £110, the income is still £10 but the yield has dropped to 9%. If, however, demand for the bond is low and the price falls to £90, the yield rises to 11%
Bond prices are influenced by the yield they pay and the rate of interest investors can earn elsewhere. If interest rates are high, savings accounts will pay more and bonds, therefore, become less attractive.
But this does not mean it is easy to decide when to buy and sell. Bonds are traded by professional investors who try to second-guess future demand for bonds by monitoring economic conditions and anticipating interest rises and falls. This makes them a good barometer of what experts think will happen to the economy. If bond prices rise, experts believe economic conditions are deteriorating and if they fall, it usually means the economy is improving.
Bond prices are also influenced by the strength of the individual company - if the company is weak it is more likely to default on its interest payments. The strength of companies issuing bonds is monitored by agencies and they give bonds ratings with AAA being the highest and C being the lowest. If a company’s rating changes, it will usually have an impact on its bond price.
There are a number of different types of bonds and demand for each type is different depending on market conditions.
Many bonds are issued by governments and are known as ‘sovereign’ debt. These bonds are usually rated more highly than bonds issued by companies. This is simply because governments are less likely to default on their debt than companies, although this may not be the case with some emerging markets.
Government bonds are often given different names – UK government bonds are known as ‘Gilts’, German government bonds are called ‘Bunds’, while US government bonds are known as ‘Treasuries’.
Governments also issue index-linked stocks. Instead of paying a fixed income like most bonds, index-linked stocks pay an income that rises in line with inflation. The maturity value is also increased in the same way. This means that investors’ capital is protected against the ravages of inflation and makes the bonds very attractive when inflation is expected to rise.
Corporate bonds are issued by companies but they are split into different types depending on the credit rating they achieve. Companies that have high ratings are known as investment grade bonds while companies with low ratings are known as high yield bonds because they have to promise higher income payouts to attract investors. Companies that do not achieve ratings are known as ‘junk’ bonds.
Companies also issue different types of bonds. Debenture stocks, for example, are secured against specific company assets while unsecured loan stocks pay higher yields but are not secured against the company’s assets. Companies also issue convertible bonds that give holders the right to convert them into shares under certain circumstances.
You can buy gilts simply through the post office or a stockbroker. Corporate bonds can only be bought through a stockbroker.
If you don’t want to buy bonds directly, you can choose from a variety of bond funds run by investment companies. These funds pool your money with those of other investors and invest in a number of bonds. A professional money manager is appointed to manage the fund, for which you pay a fee.
You can buy bond funds investing in different types of bonds, including investment grade, high yield and overseas bonds. Some funds also specialise in investing in emerging market bonds.