With interest rates and yields creeping upwards, Tim Bennett rounds up all of the bond basics.

Bonds are for many investors a key tool when it comes to portfolio building and managing Lifetime Savings. Here is a brief summary of how they work for newcomers – please speak to an Investment Manager to find out more.

An “IOU”

Bonds are issued by governments and companies seeking to raise finance. On the face of it they offer a pretty simple deal to investors – you invest in a bond, receive regular interest (or “coupons”) over its (finite) lifetime and then get a lump sum back on “redemption” or “maturity”. As such, a fixed income bond, which most of these IOUs are, has a cash flow profile that is a bit like a bank account but with a higher rate of return as follows;

Coupons and redemption values

Fixed income bonds pay a “coupon” that is a fixed percentage of the bond’s “nominal value”, usually £100. You can see this as a fixed quantity of a bond. So for example a 4% bond pays a fixed £4 per year, a 5% bond £5 and so on. The nominal value is also the amount at which the bond will be redeemed by the issuer when it matures.

This matters because, unlike say a share, with a fixed income bond you can predict your returns with absolute certainty provided you hold the bond until it matures.

An important distinction needs to be made here between this nominal value and the bond’s market price. The latter is determined by buyers and sellers who will weigh up the return on offer from a bond and compare it to other sources of income (such as bank accounts or shares) and price the bond accordingly. Since the total cash flows from a fixed income bond are known, the price has to change as market conditions evolve.

Bond yields

A key number for anyone looking at whether or not they want to buy a bond is its yield. There are two basic versions – the income yield looks at the annual income from a bond as a percentage of its current price and the “gross redemption yield” (or “yield to maturity”) expresses the total return, factoring in income and any capital gain or loss to maturity, as a percentage of the current price. The latter is more widely used and quoted. Because the income and redemption value on most bonds are both fixed, bond prices tend to move in the opposite direction to interest rates. That’s because a rise in interest rates reduces the value of a fixed income stream, relative to say a bank account, whereas a fall will boost it.

Why buy bonds?

The pros and cons of bonds may be summed up as follows;

Bonds are often used as a way of diversifying an equity portfolio because, as a rule of thumb, when markets are gloomy, bond prices tend to rise as investors seek safety while equity prices often fall as the outlook darkens. Equally, when economies are buoyant equity prices often rise and bond prices fall as investors regain their confidence.

Bonds may be bought and held via a portfolio or via a standard fund. There are pros and cons to both so please speak to an Investment Manager to find out more.

Safety checks

Although often lower risk than equities in terms of price volatility nonetheless corporate bonds in particular are certainly not risk free. Investors who may be relying on bonds for income should do some safety checks first. These may be summarised as;

  • Duration – this measures the sensitivity of a bond to a change in interest rates and is a function of both the coupon on a bond and the time remaining to maturity
  • Liquidity – some bonds are easier to sell than others
  • Credit strength – some issuers (e.g. governments) are better placed than others (e.g. companies) to meet their financial obligations to bond holders
  • Structure – some bonds have built-in safety features, such as being secured on assets belonging to an issuer, whereas others do not
  • Disclosure – there is more information available about certain types of issuer and their bonds than others

As with most investments, the key message with bonds (and bond funds) is “buyer beware” – do your homework and make sure that you understand what you are buying and the associated risks.