Bonds

When governments or companies want to raise money, they can do so by issuing bonds. These are loans which are parcelled into smaller amounts and sold to investors.

• If, for example, a company borrows £100 million through a bank loan, the money is lent directly from the bank (or from several banks) to that company. The company then pays the bank (or banks) annual interest and repays the debt at the end of a given period;
• If a company issues a £100 million bond, that money is divided up into bonds, each of which will be worth anything from £10,000 to £100,000. The company pays interest once or twice a year on its bonds and these interest payments are known as coupons. The company repays the bonds at the end of a fixed period.

Very few investors hold bonds until maturity however. Instead, they 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.

A company may, for example, raise money through a £100 million bond issue, where each bond is worth £10,000. If the annual coupon is £1000, the initial yield will be 10 per cent (the bond price divided by the coupon). If the bond is then traded on the financial market and demand for it pushes the price up to £11,000, the annual coupon will still be £1000 but the yield will have fallen to 9 per cent. Conversely, if there is not much demand for the bond and the price falls to £9000, the yield will be 11 per cent.

Demand for bonds is influenced by investor sentiment towards the issuer of the bond and the external economic environment.

The interest payment on a bond is calculated with reference to prevailing interest rates, specifically the rates paid by the Government to borrow money.

• If, for example, the Government is paying 4 per cent interest a year on a ten year bond, companies may pay interest of, say 6 per cent or more, because they are considered a higher-risk investment;
• If economic conditions change and the Government has to pay 5 per cent interest a year on a ten-year bond, the yield on company bonds will change to reflect this.

In other words, the price at which the bonds are traded will fall so the yield rises. Interest rates are fixed at the time a bond is launched so the change in the price reflects market sentiment towards the company and the wider economy.

Generally speaking, bond prices fall when economic conditions are difficult and they rise when economic conditions are good.

Bonds issued by companies are known as corporate bonds. Bonds issued by the UK Government are known as Gilts and bonds issued by the US Government are known as Treasuries. Gilts can be bought at the post office or through a stockbroker. Corporate bonds are available from stockbrokers but most individual investors gain access to these assets via corporate bond funds. These funds act in the same way as equity funds. A fund manager pools the money from a group of investors and invests in a range of bonds.