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What are bonds?
In the simplest terms bonds are great big IOUs. They are typically issued by companies or governments when they’re looking to raise more money than a bank might normally be able to pay. For example, if a company needs to raise investment for a new venture or a government has to fund spending for roads, hospitals or that new war they just have to have, they will issue bonds.
Bond Scams and how to avoid them
As investors hunt for relatively low risk returns in times of low intrest rates, there are more and more bond scams than ever before. Generally they are fake websites site up advertising double diget returns on well known brand names.
How do I buy and invest in bonds?
If you decide to buy a bond, you are effectively lending money to the bond issuer who will promise to pay it back with interest added on top. When you buy a bond, you can either choose to keep it for the duration of the term and redeem it or sell it on the bond market. The date at which the issuer will pay the bond back is known as the maturity date and your return will be termed as the yield.
An introductory guide to how bonds work
The bond market is growing rapidly. What was once the preserve of institutional investors dealing with high numbers is opening up to more and more people dealing with much smaller volumes. SIPPS and ISAs are driving demand while online investment platforms are making pricing more transparent and allowing people to execute smaller deal sizes. More and more private investors are getting involved, so we’ve put together this guide to give you all the basics about the bond market, the opportunities, risks and why you should get involved.
The different types of Bonds
- Gilts: UK Government bonds. Prices will fluctuate according to interest rates. They are AAA rated and are one of the safest options available. Most gilts are conventional and pay a fixed coupon twice a year. Index linked gilts, though, are linked to the UK retail price index of inflation (RPI). Perpetuated gilts have no maturity rate so you’re reliant on the market price. These are seen as slightly riskier.
- Corporate bonds: Issued by all types of organisations including Governments aside from the UK banks and corporations. Like Government bonds they do this to raise money for spending. The price will depend on how credit worthy the issue is perceived to be.
- Floating bonds: Coupon is fixed on a reference rate such as libor.
- Convertible bonds: You can convert proceeds into equity in the company.
- Subordinated bonds: You accept a lower claim in the event of liquidation in return for a higher yield.
Should every investment portfolio contain Bonds?
Bonds can be great addition to your portfolio for many different reasons. Here are just a few:
- Security: Bonds are often seen as a safe bet. Major governments such as the UK are unlikely to be unable to repay their debts so you can feel relatively confident you’re going to see a positive return on your money. Corporate bonds are also pretty safe. Even if a company were to go bankrupt you would be ranked above shareholders in claims on a company’s assets.
- Diversification: Bonds are a good way to avoid putting all your eggs into one basket. When markets crash, the bond markets have often been shown to move in the other direction. This inverse correlation provides a handy cushion against any unpleasant market shocks.
- Income: The income from bonds is generally higher than with equities. As populations age, people are concentrating more on investments which deliver a higher income.
- Speculation: You can speculate on future price movements. You can use liquid Government bonds to bet on future interest rate moves. If you get it right you could make a considerable amount of money.
What are the risks of buying bonds?
Although many people see bonds as being more stable, they are not without their risks. There’s always the chance that the issuer may not be able to repay some or all of its obligation. With high quality Government bonds, that’s not much of a risk, but corporate bonds can run into difficulty. Normally you will be first in line to get your money back in cases of liquidation, but subordinated bonds which trade a higher yield for a place further down the pecking order may see you lose out.
The market may move against you. The price of the bond may fluctuate depending on market conditions. If you have to take your money when the price is low you may end up with a loss. Some bonds also come with specific risks related to that issue, but these should all be spelled out in the contract. One of these could be ‘call provisions’ which allow the issuer to repay it at an earlier date.
Event risks can also have an impact such as market crashes or new punitive tax regimes. You should keep an eye on movements in the market to ensure you’re not caught by surprise.
Understanding bond credit ratings
Most issuers will have been rated by one of the independent credit rating organisations such as Moodys or Standard & Poor’s. These are badges which show how reliable a bond issuer is. They will be categorised as followed:
- AAA: The highest rating agencies can give.
- AA: Still very strong, with only minor differences to AAA.
- A: Extremely strong ability to repay although they may be affected by movements in the market.
- BBB: Adequate ability to meet its commitments, but adverse effects from the market are more likely.
Anything below BBB should be treated with caution. These higher risk bonds will generally offer a higher return in much the same way as poor credit loans attract higher interest. The yields are higher, but so are the risks.
Index Linked Gilts
Index-linked gilts are Government issued bonds which are linked to the rate of inflation. A gilt will follow the retail price index which means its price will rise in line with inflation. This addresses one of the key risks that a bond with a long maturity may see its value eroded by inflation. These gilts will have their principal and coupon payments adjusted in line with inflation. However, if inflation were to fall over the life of the bond the value of the gilt could potentially fall to lower than its face value.
Pricing this can be complicated and so can trading. It often depends on where the market thinks inflation will be at a given point. This is termed the break-even or spread inflation which determines how much you may buy or sell them for. These can be used to compliment other bonds to hedge against inflation risk.
Calculating the yield of a bond
In bonds the yield is the annual return on investment and refers to the purchase price and the promised interest which is also known as the coupon payment. The coupon rate is fixed but the purchase price fluctuates depending on interest rates.
The value of your bond will be driven by supply and demand. This relies on the credit worthiness of the issuer and also interest rates. If interest rates fall, a fixed rate bond becomes more appealing. Likewise, its value will fall if rates rise.
The current yield refers to the amount of yield you receive every year. This is calculated by dividing the annual interest by the purchase price.
The yield to maturity is the total return an investor receives for holding the bond until it matures. It takes into account the redemption price and all the interest paid from time of purchase until maturity.
Buying bonds - where and how to do it...
You can buy bonds through a brokerage but online brokers make it easier and less expensive for individual investors to trade bonds. Specialised brokers tend to require a high initial deposit which might put it out of range for many people. Online brokerages are less expensive or you can try investing in bonds through mutual funds or exchange traded funds (ETFs) which invest in bonds. These operate in much the same way as stocks and shares.
If you’re buying on the open market you should remember you are buying bonds from other investors rather than from the issuers themselves. Broker fees can be easy to misunderstand. Even if a broker says they are commission-free they may quietly mark up the price. Most banks or brokers should allow you to buy government bonds direct, but if they don’t you can go directly through a Government agency.
How to build a diverse portfolio of bonds
Rather than buying bonds separately, it pays to include them as part of a portfolio. You can then structure your investment deliver a suitable mix of investment and return. Ideally you should have a diverse mix across assets and classes, including different types of bonds. You should find your perfect balance between risk and yield and structure the portfolio so that it delivers a consistent and reliable income flow. In an ideal world, a portfolio will be more than the sum of its parts offering less volatility than its component investments.
Building a portfolio will be a different process in each case. From the start, you will need a clear idea of your goals and objectives. Think about what you want to get from this, how long the money will be invested, your appetite for risk and hoped-for return. All these will impact the balance of your portfolio.
Glossary - simplifying bond terminology
There are all sorts of terms you’ll need to get familiar with. Here are some of the most common.
- Par value: This is the face value of a bond.
- Discount: A bond trading at less than its face value will be trading at a discount.
- Credit rating: Issues will have a credit rating issued to them by one of the main credit rating agencies: Standard & Poor’s or Moodys.
- Market rates of interest: The market interest rate will affect the price of a bond. If interest rates rise a bond will have to be sold at a discount to remain competitive. If they fall the bond price may rise.
- Premium: If they are trading higher than face value they will be trading at a premium.
- Coupon: This is the interest rate of the bond. For example, a bond of £1,000 at 5% interest means the issuer promises to pay £50 of interest per year.
- Call provision: Some issuers will have a call provision on the bond which means they can choose to repay it earlier. This may affect the overall yield and represents an issue-specific risk.
- Maturity: The point at which the bond will be paid out.
- Accrued interest: The theoretical amount of interest you’ve built up – namely not yet paid out interest on the bond.
- Bid and ask price: The bid price is the highest price a buyer will pay. The ask price is the lowest price offered by sellers.
- Spread: The difference between the ask and bid price
- Base points: This is one hundredth of one percentage point. For example, let’s say yield falls from 5.45% to 5.40% that means it has fallen five base points.
Some of the best books about buying and investing in bonds
Want to develop your skills? Here are some of the best books about bonds to help you on your way.
- The Sterling Bonds and Fixed Income Handbook: A practical guide for investors and advisers
An excellent guide to the UK bond market by Mark Glowery, who set up the fixedincomeinvestor.co.uk website.
- The Bond Book by Annette Thau
This tops almost every list and is a great handbook for any seasoned investor wanting to get involved with bonds or equity investors who want to diversify.
- The Strategic Bonds Investor by Anthony Crescenzi
After the financial crisis bonds have been touted as one of the few stable investments left. This great guide helps you understand how to maximise your returns from bonds.
- Step by Step Bond Investing by Joseph Hogue
‘Ditch the stock market game’, this book tells you, ‘learn about the safety and returns of bond investing.’ And that’s pretty much what this book offers – a great starter guide for the newbie bond investor.
- The Complete Guide to Investing in Bonds and Bond Funds by Martha Maeda
A great Bible for anyone who has never invested in bonds before. This shows you the ropes and helps you understand the peculiarities of bond investing.
Buying and investing in Bonds FAQs
- Can private investors trade bonds? Yes, but many brokerages require high initial deposits. Online brokers are more accessible.
- How much should I invest? It’s easier than it used to be to invest on a smaller scale, but income may get swallowed up by dealing costs. To be viable, you may need to invest more than £1,000. Some bonds have minimum buy amounts.
- Where can I find credit ratings? Most issuers will display their credit ratings. Alternatively, you should be able to look them up on the websites of ratings agencies. Check out moodys.com/ and www.standardandpoors.com
- Are returns better than equities? Normally equities do better in the long term. However, at times of market volatility bonds can out-perform equities. They also provide a more reliable income stream.
- When I sell bonds, do I miss out on interest? You will receive a pro-rate payment based on accrued interest.
- Can I include them in an ISA? Yes, but it must adhere to certain requirements such as being listed on a recognised stock exchange and having a maturity of more than five years.
- Can I include them in SIPP? Most providers will allow you to include bonds as part of a SIPP.
- What about tax? If you hold it in an ISA or SIPP it may be part of your tax-free income. Other bond income will have to be included on your tax return.
- Do I have to pay capital gains tax? Gilts incur no capital gains tax and neither do most qualifying corporate bonds.