Bonds: The basics

Share this

Bonds have rarely been out of the headlines recently as Italian bond yields have soared and German rates sunk. Meanwhile, spooked equity investors have been piling into bonds and bond funds. But how do bonds work and how can investors buy them?

What is a bond?

Bonds are essentially IOUs issued by companies and governments to raise capital. Investors buy this debt and, in return, the issuer promises to pay a set amount of interest every year plus the capital at a set future date. Bonds are also known as fixed income and fixed interest because they pay out a fixed amount.

There are two main types of bond: government bonds, also called gilts, and corporate bonds, issued by companies.

What's the difference between corporates and gilts?

Gilts are considered safer than corporate bonds, as governments are less likely to go bust - although the eurozone crisis is changing this perception. They are issued either as short or long-dated bonds - it's possible to buy a gilt for 50 years.

Corporate bonds are more risky than gilts, although generally less risky than equities. Corporate bondholders are higher up the hierarchy for a payout than shareholders should the company default.

How are bonds graded?

Bonds are graded in terms of credit risk, so investors have a steer on how risky their investment is. Those rated AAA to BB are known as investment-grade bonds and are issued by the bigger blue-chip companies and governments. Those rated BB and below are called junk bonds. They are also referred to as high-yield bonds because they pay a higher rate of interest.

How do prices and yields work?

Like other traded securities, bond prices can go up or down. Investors should pay attention to the yield, which is a proportion of the bond price. The two have an inverse correlation, so if the price goes up, the yield goes down.

For example, if a corporate bond has a value of £1,000 and has a coupon of £50 for five years, the yield is 5%. But if the bond's price falls to £900, the yield rises to 5.6%. To calculate that yield, the equation is £50/£900 x 100, which gives a yield of around 5.6%.

How do I buy individual bonds?

In 2010 the London Stock Exchange launched the Order Book for Retail Bonds, which is a bond platform for retail investors.

Bonds are traded through an LSE member broker in the same way as shares. Corporates are available from as little as £100, but the standard lot size for gilts is just £1, which offers a cheap entry point for retail investors.

Royal Bank of Scotland recently issued a seven-year inflation-linked bond, which pays a coupon of 2% adjusted in line with the Retail Prices Index. It is available in denominations of £1,000.

What about bond funds?

A more diversified way for a first-time investor to access bonds is through a dedicated bond fund, where a fund manager invests in a range of bonds.

There are many different types of fund. Some funds focus on investment-grade bonds, while others concentrate on high-yield bonds. Some funds focus on specific regions, while other invest globally. Strategic and dynamic bond funds allow managers to invest wherever they find value.

More sophisticated investors could consider the growing range of fixed-income exchange traded funds, which track indices comprised of a basket of bonds. However, while they are a cheap and liquid way to access the sector, they can be complex.

Where should I invest now?

Patrick Connolly at financial advisers AWD Chase de Vere suggests choosing a fund with good-quality corporate bonds, as they are often considered a relative safe haven. "The best-quality bonds tend to do well when stockmarkets are falling. However, it would be wrong to assume bonds cannot fall in value. They can and they do," he says.

During the credit crunch of 2008, the average investment-grade bond fund fell by about 10%, and some fell more than 20%. In the same year, Connolly says, the average high-yield bond fund, which invests in less secure companies, fell by around 25%.

Adrian Lowcock, senior investment adviser at Bestinvest, advises income investors against buying government bond funds at the moment. "Yields on UK and US bonds are at an all-time low and might fall further," he says.

This article first appeared in the December 2011 issue of Money Observer.