Bond brokers let you buy and sell investments such as corporate bonds, retail bonds on ORB, gilts & Government bonds. Bonds can either be bought as a long-term investment to receive income through interest payments (coupons) or traded in the short-term based on their market price. In our guide on how to buy bonds, we explain the different types of bonds you can buy, where to buy them and the potential risks and rewards of buying bonds.
Bond Investing Explained
Investment bonds are a type of income-generating investment that can pay regular interest payments called coupons. 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.
When you buy bonds you will be 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.
When investing in bonds, it’s important to consider your investment goals and risk tolerance. The best bonds for you will depend on several factors, including your income requirements, your investment horizon, and your ability to tolerate risk.
While the amount of interest paid on a bond is fixed, the yield (the interest payment relative to the current bond price) will fluctuate as the bond’s price changes. A bond’s ‘yield to maturity’ is the total return you will receive for holding the bond until it matures. Yield to maturity takes into account the redemption price and all the interest paid from the time of the purchase until maturity.
It’s important to understand that with bonds, risk and return are highly correlated. This means that the higher the yield on a bond, the higher the risk of default. One of the most common mistakes beginner investors make when choosing their first bonds is reaching for high yields. High-yield bonds can deliver high returns at times, however, these high returns come with a higher level of risk. For example, the issuing entity may declare bankruptcy and be unable to pay you back your initial investment.
When assessing bond risk, you can turn to credit rating agencies such as Standard and Poor’s, Moody’s, and Fitch for guidance. These agencies give bonds credit ratings, which indicate the probability of default. Typically, bond ratings are grouped into two main categories: investment grade (higher-rated bonds) and high yield (lower-rated bonds).
One of the easiest ways to manage risk when investing in bonds is to build a diversified portfolio of securities. A diversified portfolio might include several types of bonds, including government bonds and corporate bonds, as well as bonds with different maturities to reduce interest-rate risk.
Making money from investing in bonds
There are two main ways to make money from bonds.
- Coupons (interest payments): The first way to profit from bonds is to hold them until their maturity date and collect interest payments along the way. Interest is usually paid twice a year.
- Price speculation: The second way to make money from bonds is to sell them at a higher price than you paid for them. For example, if you buy £10,000 worth of a bond and the market value of your bond investment increases to £11,000, you can sell for a £1,000 profit. Bond prices can rise (or fall) for many reasons, including changes in interest rates, changes to a borrower’s credit risk profile, and the time to maturity.
Investment bond valuations
Each bond has a ‘par value’, which is the amount of money that the bond issuer promises to repay investors at the bond’s maturity date. However, a bond can trade at its par value, a premium, or a discount. Bonds trade at a premium when the current price is higher than the par value. Discount bonds are the opposite, selling for lower than the par value.
A bond’s value can be influenced by several factors, including:
- Interest rates: Interest rates are the biggest driver of bond prices and all bonds are affected by interest rate changes, regardless of the issuer or the credit rating. Bond prices are inversely proportional to interest rate movements. So, if interest rates rise, bond prices tend to fall. If interest rates fall, bond prices tend to rise.
- Time to maturity: Bonds are typically paid in full when they mature. Since a bondholder is closer to receiving the par value as the maturity date approaches, a bond’s price tends to move toward par as it ages.
- The entity’s credit rating: If a borrower experiences a credit downgrade, its bonds are likely to fall in value. By contrast, if a borrower experiences a credit upgrade, its bonds may rise in value. It’s worth noting that different brokers can offer different prices for the same bond. Because bonds are not traded in a centralised location like stocks are, brokers can set their prices.
In theory, the true value of a bond can be obtained by discounting the bond’s expected cash flows to their present value, using an appropriate discount rate.
Advantages of investing in bonds
- Regular income: Investing in bonds can be a good way to generate passive income. The yields on bonds are generally higher than the interest rates on cash savings accounts. Bonds offer a predictable income stream, paying you a fixed amount of interest several times per year.
- Diversification: Investing in bonds can be a good way to diversify your investment portfolio. If you own a portfolio of stocks and bonds, the bonds may provide protection when share prices are falling.
- Lower risk: Bonds are generally seen as lower-risk investments. This is particularly true when it comes to government bonds, as governments such as the US and the UK are unlikely to be unable to repay their debts. This means that you can be relatively confident that you’re going to see a positive return on your money if you hold the bond until maturity. Adding bonds to a portfolio of stocks can add stability and help lower overall portfolio risk because bonds behave differently to stocks.
- Higher interest rates: Higher returns than cash savings. Yields on bonds tend to be higher than the interest rates on cash savings accounts.
- 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.
Disadvantages of investing in bonds
- Lower returns than shares. Over the long run, bonds have generated lower returns than shares for investors.
- Less transparency. There’s less transparency in the bond market than in the stock market, so brokers can sometimes get away with charging higher prices for individual securities.
- Interest rate risk. Bond prices are inversely related to interest rate movements. So, if interest rates rise, your bonds may fall in value.
- Credit risk. When you invest in a bond, you face the risk that the issuer may default on its obligations. You risk losing out on interest payments, getting your principal back, or both. With bonds it is possible to lose your entire investment.
- Price falls: 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.
Different types of bonds offered by bond brokers:
- 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 creditworthy 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.
- 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.
Investment 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.
Bond broker terminology
When investing in bonds you will at some point have to talk to your broker on the phone as not all bonds are available online. Whilst you can buy bonds online easily enough at issue and through the market, selling bonds can prove a little more nuanced. Here are is a glossary of the most commonly used terms when dealing in bonds:
- Par value: Par 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 a bond is trading higher than face value they will be trading at a premium.
- Coupon: A coupon 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: Bond maturity is the point at which the bond will be paid out.
- Accrued interest: Accrued interest is 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 spread is 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.
- Yield: 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 creditworthiness 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.
- Yield to maturity: 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.
Bond investing books:
Here are some of the best books about investing in UK bonds:
- 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 and covers absolutely everything you need to know about investing in bonds.
- 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.
Bond trading versus investing
Investing in bonds refers to buying bonds for the purposes of generating income through coupon payments in the long term. Bond trading is short-term speculation on the price of the bond moving up or down.
If you are looking to invest in bonds, you will need a broker like Hargreaves Lansdown that allows you to own the underlying bond securities or own a ‘fractional’ bond though ETFs with Interactive Brokers. Some trading providers, such as IG Index, only allow you to trade bond price movements via Contracts for Difference (CFDs). With this type of financial instrument, you do not own the underlying bond securities.