Investing 101: What is a bond?
A bond is an investment instrument that in many ways works just like an IOU. Bonds are usually used by companies and governments to borrow money to fund their activities.
When you buy a bond, you’re buying a small piece of a much larger debt, or in other words, you are one of perhaps hundreds, thousands, or millions of others lending money to the issuer of that bond.
How Bonds Work
The issuer of the bond is the company or government that is borrowing your money, so we can think of them as the ‘borrower’. The issuer promises to pay the bond back at an agreed date in the future, known as maturity.
The issuer also promises to pay interest payments known as ‘coupons’ to the bond holder until that date.
The coupon is expressed as a percentage of the face value of the bond, also called the principal or nominal amount. For example, UK Government bonds have a nominal value of £100 meaning the UK Government issues the bonds in £100 slices, and it is this £100 that will be returned to the bond holder at maturity.
Once you have invested or purchased the bond, you have two options. You can hold the bond until maturity, at which point you will receive the principal or nominal amount back.
Alternatively, you can sell the bond to another investor who wishes to become the bond holder and who will now receive the coupon payments instead.
When this happens, you may sell the bond above the nominal/principal value (known as a premium) or below the nominal/principal value (known as a discount).
Whether this happens, and by how much, will depend on what interest rates and consequently other investment returns are like in the market at that time.
For example, if better returns are available elsewhere for a similar amount of risk (make sure you’ve read risk v return here), then the bond is likely to trade at a discount to adjust for the reduction in the ‘value’ of the coupon.
If the coupon payment on the bond is greater than other investments with a similar amount of risk, or higher risk investments are not paying much more in returns, then the bond is likely to trade at a premium to adjust for the increase in the value of the coupon.
We can see in the image below a screenshot of the Hargreaves Lansdown platform where you can buy and sell bonds, a number of UK Government bonds are priced at a premium or discount to their nominal/principal value of £100. This is because the coupon they are offering is higher or lower than current interest rates.
When considering bond types, we usually view them in two main categories determined by who the issuer (or borrower) is. Bonds which are issued by governments are known as Government Bonds. Bonds issued by Companies are known as Corporate Bonds.
Government bonds are generally considered lower risk. When we talk about risk, we are talking about the risk that the issuer is unable to pay the coupon (interest) payments or the nominal (Face) value at maturity, or perhaps both. This is known as default.
Because governments have constant flows of money from taxes, we perceive them as being less likely to default on the bond payments. However, in saying this, not all governments are created equal. The UK and US for example, have never defaulted on their bonds, however the same can’t be said for the likes of Argentina or Greece.
Corporate bonds on the other hand are still generally considered lower risk in comparison to other investments like shares because the legal structure of a bond means that the company has an obligation to pay bond holders first, before shareholders receive any money and as such, the chance of you not having your money returned is reduced.
Corporate bonds are however higher risk than government bonds, because a company could enter financial difficulties without the same protection governments have.
When considering corporate bonds (and government bonds to some extent) it’s important to consider the credit rating of the issuer. Just like we as individuals have credit scores which lenders will use to determine how much, if at all we can borrow, the same principle applies to bond issuers.
Independent credit rating agencies will assess the financial position of the issuer and give them and their bonds a credit rating. As you should know from risk v return , a bond with a lower credit rating, and consequently a higher risk of default, is going to pay a higher rate of return to compensate for this risk.
As such, you should be considerate of so called ‘Junk Bonds’ also referred to as ‘High yield bonds’. These bonds will have attractive coupons, much higher than those offered on safe government bonds like UK Gilts, but remember, this is because they will have a lower credit rating and higher risk of default.
💷- Bonds pay out income in the form of coupon payments. If you’re looking to receive income from your investments, bonds are a pretty good bet.
Unlike shares, the investment return (income) is usually fixed, so unless the issuer becomes insolvent (eg. enters financial difficulties) you are always going to receive that coupon payment. If you’re relying on your investment to give you income, consistency of that income flow is extremely important.
📈- Bonds are generally considered low risk, as we discussed, this needs to be taken in the context of other investment options and after consideration of the credit rating of the issuer, but as a general principle, bonds are considered a fairly safe investment, particularly in the case of government bonds issued by the likes of the UK and the USA.
🤑- You can make a profit if you resell the bond at a higher price on the secondary market, rather than holding it to maturity. This shouldn’t be your key driver for investing in bonds, because if you’re looking for capital growth (profit) shares are likely to be more suitable.
However, there is still a possibility that interest rates move in your favour and you are able to sell the bond for more than you bought it for.
👇- Bonds pay out lower returns than other investments like stocks. We know this is because of the relationship between risk v return , but if we are investing with specific goals in mind, bonds may not be the most suitable investment to help us achieve those goals.
🏢- Companies (and sometimes governments) can default on bonds. This means the issuer will stop paying your coupon payments, and you will now have to wait for liquidators to process the companies assets to see if you will be able to recover your principal amount.
How do I invest in Bonds?
When choosing to invest in bonds, you have two main options. The first is to purchase the bond yourself, known as ‘direct investing’. Investing in this way will require you to research and choose which bonds you want to invest in. When doing this you should consider all the information above, such as the credit rating of the issuer, and whether the returns (coupons) are suitable for your financial goals and whether they match the risk you are taking on.
As you are a smaller private investor, rather than a large institution, you will be purchasing bonds on the secondary market, so be sure to check how much the bond is trading at relative to it’s nominal amount.
You can research your bonds and purchase them on an investment platform like Hargreaves Lansdown or Vanguard. Both of these platforms will provide historic market and price information you need to make your decision. Make sure you consider fees as well, purchasing bonds is similar to purchasing shares, you will be charged a brokerage fee for using the investment platform to buy the bond.
The second option is to invest in a bond fund. By investing in this way, you now receive access to a range of different bonds, perhaps from different issuers, with different maturities.
By investing in a fund like this, you now have what is called ‘diversified’ exposure. This means that rather than having all your money in a single bond with a single issuer, your money is spread across a number of different bonds reducing the impact and risk to your money from any one of the bonds being defaulted on.
Investing in funds through Hargreaves Lansdown or Vanguard does not incur a brokerage fee, however do consider that the fund itself will have costs from employing people to manage and administrate the fund, making the investment decisions and managing the money.
This is referred to as the ‘Ongoing charge’ or ‘OCF’ and is usually around 0.5-1% however can be much lower or higher, so be sure to check this out. Hargreaves Lansdown often has deals with fund providers to significantly reduce this fee, so look out for ‘saving from Hargreaves Lansdown’ on fund fees.
ALLIANZ GILT YIELD fund has an Ongoing charge (annual fee) of 0.54% however Hargreaves Lansdown reduces this by 0.20% making the fee just 0.34%.
Equally, some funds can have an initial charge for entering the fund. You should consider if the initial charge is worth it for the returns, or again, check if this fee has been reduced (usually removed completely) by Hargreaves Lansdown.
You should now have a good base knowledge in what bonds are and how you can invest in them. Be sure to check them out on one of the investment platforms mentioned above, and make sure to do your research before investing!
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