What are bonds?
Bonds play a massive role in the global economy, essentially serving as IOUs between governments, businesses, and the people who invest in them. How do bonds work, and why are they a good investment? When you buy a bond, you are lending money to the bond issuer, which can be a corporation or a government. Governments use bonds to raise money and as a monetary policy tool to regulate the money supply in the economy. Bonds are generally viewed as a low-risk investment, especially government bonds.
How do bonds work?
A bond is an IOU where you lend money to the government or a corporation. In return, they promise to pay you a regular fixed rate of interest for a specified number of years. At the end of the period, they repay the original amount to you.
Government bonds are issued by governments, and are known as gilts in the UK. They are considered amongst the safest investments because they are backed by the government’s ability to raise money through taxation.
Corporate or business bonds are issued by companies looking to raise capital for expansion, acquisitions or other business needs. They are higher-risk investments as businesses can fail, and as such, they pay higher interest than government bonds.
The workings of a bond
To explain how bonds work in practice, let’s use an example of a 10-year government gilt with a face value of £1,000 and a coupon rate of 4%. You’ll pay £1,000 to purchase the bond (face value) and receive £40 in interest per year (4% on £1,000) for 10 years. When the bond matures after 10 years, you will receive the original £1,000 back.
The coupon rate, or interest rate, is fixed when the bond is issued. This is why bonds are often referred to as ‘fixed-income’ securities.
The relationship between bond prices and interest rates
Once issued, bonds can be bought and sold on the secondary bond market. Bond prices do fluctuate, as they are affected by interest rate movements.
There is an inverse relationship between bond prices and interest rates. When interest rates rise, bond prices fall, and they increase in price when interest rates drop. How does this work in practice? If you hold a £1,000 bond paying 4% interest, and interest rates rise to 5%, new bonds will now pay a higher rate of interest. Your 4% bond isn’t quite so appealing now. To sell it, you will have to drop the price below £1,000 for it to return 5% interest. Your bond pays a fixed amount of £40 interest a year. To achieve a 5% return, an investor will only want to pay £800 for your bond (£800 x 5% = £40).
If interest rates drop to 3%, your 4% bond becomes more valuable and will be worth £1,333 (1,333 x 3% = £40).
Bond yields explained
Once bonds are traded on the secondary bond market, the yield is the actual return you get from a bond. This differs from the coupon rate or interest rate stated on the bond. If you purchase a bond lower than its face value, your bond yield will be higher than the coupon rate. The opposite applies when you pay more than the face value for a bond, as your return will be lower than the coupon rate. There is a formula that calculates the bond yield, which is:
Yield = (Annual interest payment / current bond price) x 100
To illustrate this, assume you pay £1,400 for a bond with a face value of £1,500 and a coupon rate of 5%. The annual return or interest on the bond is £75 (£1,500 x 5% = £75). Using the above formula, the yield on the bond is 5.35% when you pay £1,400 for the bond (£75 / £1,400 ) x 100% = 5.35%.
In this example, if you pay £1,550 for the bond, your yield or return will be 4.8%. This is calculated asfollows: (£75 / £1,550) x 100% = 4.8%.
Benefits of investing in bonds
Holding bonds as part of your investments offers several benefits, along with adding another layer of diversification to your portfolio. Some of the main benefits of bonds are:
- Protecting capital – this is especially true of government bonds that are regarded as safe options for preserving capital, especially during volatile economic landscapes.
- Providing a regular income – they generate a regular and consistent income, which is important if you are dependent on the income, for example, if you are retired.
- Balancing portfolio risk – bonds help to balance portfolio risk, particularly when markets are falling, as their prices can increase.
- Less volatile – bonds historically experience lower price swings than stocks and shares.
Inherent risks of bonds
While bonds are considered less risky than shares, they aren’t risk-free. The following factors can impact the returns and value of bonds:
- Interest rate changes – rising interest rates can cause bond values to fall. This will impact your capital if you need to sell the bond before it matures.
- Credit risk – it is possible that the bond issuer defaults on payments. This is why corporate bonds pay higher rates than government bonds, to compensate for the higher associated risk.
- Inflation risk – if inflation outpaces the bond interest rate, this can erode the purchasing power of the bond over time.
- Liquidity risk – this means some bonds may not be easy to sell quickly without reducing the face value of the bond.
Bonds are an important part of your investment strategy, helping you maintain a balanced and diversified portfolio. They don’t offer the returns that shares can provide during bull markets, but they offer stability and regular income. Whether you are approaching retirement and need a regular income, or you’re a younger investor looking to diversify your portfolio, bonds deserve a place in your investment pot.
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