When talking about investing we automatically think of the stockmarket. Buying shares in a business is easy enough to understand. But there is another market – the bond market. But what exactly is a bond?
At Continuum, we look at the answer to that question – and at whether bond investment could provide answers for you.
An investment in lending
A Bond is an IOU that can be traded in the financial markets.
If a government or a corporation wants to borrow money, they can sell bonds to investors. Governments issue bonds to fund roads, schools and infrastructure for example. Corporations use them to raise money to fund investment or takeovers, without the risk of losing control, as can happen with shares.
Issuing bonds can raise much larger sums than a bank or other lender could provide, because they can allow investment from many thousands of individuals, pension and investment funds, insurance companies and others.
For those who invest in bonds, there are two sources of return. The first is a steady stream of payments with a set interest rate, usually at the rate of two a year, from the bond issuer. The second is a final repayment when the bond matures.
You can think of bond investment as much like making a loan, getting regular interest repayments, and then getting the original sum repaid.
But things are not quite that simple.
Not all bonds are created equal
There are many bonds issued every year, but they are only as good as the government or corporation that provided them. A bond issuer could default. Governments and businesses do collapse, leaving bond holders with worthless scraps of paper.
The higher the risk, the better the interest payments will be – because the issuers need to pay more to get investors to buy their bonds.
There are organisations that rate the quality of each bond by assigning a credit rating, so you know how likely it is that you’ll get your expected payments. The 2 best known agencies that rate bonds are Standard & Poor’s (S&P) and Moody’s Investors Service. They have similar ratings systems, based on the issuer’s current financial and credit histories.
If a bond rating is low—”below investment grade”— it may have a high yield but it will also have a risk level more like a stock. If the bond’s rating is very high, you can be quite confident you’ll receive the promised payments – but these will not be as large as those of less dependable bonds and it is also possible for historically stable companies to collapse.
The most secure bonds are issued by stable governments of wealthy countries. In the UK, government bonds are referred to as “gilt-edged securities” or just gilts. In the US they are called Treasuries, in Germany they are Bunds and in Japan JGBs.
Less stable government and corporate bonds may be referred to as Investment grade. Investment-grade bonds might not offer huge returns, but the risk of the borrower defaulting on interest payments is still small.
The riskiest bonds are referred to as Junk Bonds. These pay high yields because the borrowers don’t have any other option. Their credit ratings are less than pristine, making it difficult for them to acquire capital – but the returns can be the highest.
How long you hold the bond also comes into play. Bonds with longer durations – say a 10 year bond versus a 1 year bond – pay higher yields. You are paid more for keeping your money tied up for a longer period of time.
Should you buy bonds?
This is only a very basic introduction to the world of bonds. There are many other factors that make bond investing attractive especially for professional investors. You can for example trade bonds after they have been issued, and the price can vary along with interest rates. As interest rates rise, bond prices fall. That’s because when rates climb, new bonds are issued at the higher rate, making existing bonds with lower rates less valuable.
But what can they offer you?
The simple answer is that investing in bonds can provide income – and that they can tend to rise when stocks fall – making them a valuable way to diversify your portfolio in uncertain times.
If you are investing for income, the chances are that some form of bond investment might form part of your investment plans – but as with any other type of investing, expert help is essential.
At Continuum we can provide the help you need.
The information contained in this article is based on the opinion of Continuum and does not constitute financial advice or a recommendation to suitable investment strategy, you should seek independent financial advice before embarking on any course of action.
The value of investments can fall as well as rise and you may get back less than you invested.
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