Bonds are a common feature of many people’s investment portfolios and if you have a pension, the chances are that some of your retirement savings are invested in them.
Bonds usually appeal to those who are more risk-averse, as they tend to be lower risk than other types of investments such as stocks and shares, but if you’ve never bought bonds before they can seem a little confusing.
Here we explain what bonds are, the various different types to choose from, and how to invest in them.
What are bonds?
Bonds, otherwise known as fixed-income investments, are effectively an IOU from a company or government that they sell to raise money for certain projects or government initiatives. A bond is therefore essentially a loan, but instead of you borrowing money from the government or a particular company, you are the one lending it, and gaining interest payments from it. Government bonds are known as gilts in the UK.
Corporate bonds and gilts are not to be confused with savings bonds offered by banks and building societies, which are essentially savings accounts that run for a set term and pay a fixed rate of interest.
How do bonds work?
When you buy a bond, you agree to lend your money to the company or government for a specific amount of time, and in return, they should pay you a regular income in the form of interest before giving you your money back when the bond matures. The fixed rate of interest you receive is known as the ‘coupon’. So unlike other types of investment, the purpose is not to grow your initial investment, but rather pay you a steady income over the term of the bond.
The amount of time you agree to lend your money for could be anything from six months to 10 years, with some bonds lasting for as long as 30 years. When you buy a bond, you will usually agree to receive a set interest rate for the bond’s term, with interest typically paid out twice a year.
When investing in bonds, the biggest risk for investors is that the company issuing the bond runs into financial difficulties, and can’t keep up with its interest payments – or even worse is unable to repay investors their capital. Gilts are the lowest risk bonds you can invest in, as it’s unlikely the UK government will go bankrupt so your money and any interest you might be due should be safe.
What affects the price of bonds?
The price of bonds is mainly determined by what’s happening with interest rates, and by how solvent the bond issuer is considered to be.
Each bond will have a credit rating, which is worked out by credit rating agencies such as Moody’s and Standard & Poors. This rating is intended to provide an indicator of how risky that bond is likely to be, or in other words, how likely the company or government issuing it is going to be able to pay back its debt.
Bonds rated C, CC or CCC are considered very high risk, with those rated B, BB or BBB having a lower risk of default. The ‘safest’ bonds, or those considered to have a very low risk of the issuer defaulting, are labelled AAA or AA. If a bond has its credit rating lowered, then its price will go down as well.
The price of bonds also falls when interest rates rise. This is because when interest rates go up, new bonds are likely to be issued offering higher ‘coupon’ rates. As a result, existing bonds look less attractive, which leads to their prices dropping. Conversely, bond prices rise when interest rates fall, as investors are willing to pay more for bonds offering higher interest payments.
Bond terms to know
As with many financial products, there’s plenty of jargon to get to grips with if you’re considering investing in bonds. Some of the terms you might come across may include the following:
- Par value – sometimes known as face value or nominal value, par value is the price the bond was initially bought for.
- Coupon rate or bond yield – this is the interest rate that indicates how much you will receive each year. So for example, if the par value of your bond was £1,000 and your coupon rate was 3%, you would receive £30 a year. This is usually split over two payments, issued every six months.
- Term or redemption date – this could appear as either two years or 2023, both of which essentially mean the same thing – that the bond will last for two years and that in 2023 you should get the money you invested back.
How do you invest in bonds?
If you are interested in investing in bonds or gilts, you have a couple of options to choose from. You can either invest directly with the company or government, or you can invest in a bond fund.
Direct investing
If you want to buy UK government gilts, you can do this through the Debt Management Office website, or if you want to invest in specific corporate bonds, you can do this through the London Stock Exchange’s Retail Bond platform. Gilts and corporate bonds are often traded on a secondary market too.
You can also buy bonds through a broker or an investment platform. Always make sure you fully understand the costs before you commit.
Investing in bond funds
Most people invest in bonds via a bond fund, which essentially pools money from a number of investors and then invests in a variety of gilts and bonds.
When you invest in a bond fund, the financial risk is reduced as your investment is spread across a large number of gilts and bonds. However, this doesn’t mean bond funds are without risk, and there’s still a chance that you could get back less than you put in. Bond funds also offer more flexibility than buying a bond directly, as there is no set maturity date, you may be able to withdraw your money sooner and at shorter notice compared to a direct bond.
Bear in mind, however, that investing is for the long-term, so you should be prepared to leave your money untouched for at least five years as an absolute minimum, but preferably ten years or longer.
If you opt for a bond fund, you’ll usually have to pay an annual charge to the fund manager for their services. This charge is typically between 0.5% and 1% standard corporate bond or gilt funds.
Are bonds a good investment?
Whether bonds are a good investment for you really depends on your situation and what you are trying to achieve from your investments.
If you’re looking for high returns and are comfortable accepting a high level of risk, they may not be a great option, but if you are looking for a relatively safe investment option that will pay you a steady income or help you to diversify your portfolio, they may be worth considering.
While bonds don’t have the same potential to generate the sorts of returns that other higher-risk investments do, they still make up a part of many people’s investment portfolios, particularly those who are approaching retirement and who perhaps want to steer clear of sudden market setbacks just before they stop working.
Are bonds risk-free?
No investment is ever entirely without risk, and when you invest in a bond, there is a risk that you could lose your money if the company goes bust. Bonds have been falling alongside the stock market in 2022, albeit less drastically, as rising interest rates can be negative for bonds.
While traditionally bond investors have more protection than shareholders, as bondholders are usually paid before shareholders when a company fails, this does not mean there will be enough money to repay you in full, or at all. Gilts are often seen as a safer option as it’s highly unlikely that the UK government will go under.
Most bond providers will be members of the Financial Services Compensation Scheme (FSCS) which is a scheme that protects your investments and savings if a company fails. You will only be covered up to £85,000 per person, per firm, so it’s always worth considering spreading out your investments to boost your protection.