Buying shares in a business is easy enough to understand. But there is another way to invest in the performance of a business without buying shares in it, by investing in bonds. But what exactly is a bond?
At Continuum, we look at what a bond is, what it does – and whether bond investment could provide answers for you.
Investing in lending
A bond is essentially a loan, which pays the lender. A government or a business can borrow by selling bonds to investors if it needs to raise funds. Governments issue bonds to fund roads, schools and infrastructure. Corporations use them to fund investment in plant or acquisitions.
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.
Why do they lend? To enjoy two sources of return. The first comes as payments with a set 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.
A cash income and your money back sounds like the perfect investment. But things are not quite that simple.
Some bonds are gilt edged. Some are junk
Bonds are only as good as the government or corporation that provided them. Some Governments and businesses can potentially collapse, leaving bond holders with worthless scraps of paper.
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.
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. The borrowers have credit ratings that are less than pristine, making it difficult for them to acquire capital in any other way – so they have to offer bonds at generous rates. The risk can be high – but potentially, so can the returns.
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 two best known agencies that rate bonds are Standard & Poor’s (S&P) and Moody’s. They have similar ratings systems, based on the issuer’s current financial and credit histories.
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?
Bonds can provide income. They tend to rise when stocks fall – making them a valuable way to diversify your portfolio, and enjoy predictable returns if income, rather than capital growth is your objective.
The time might be right to look at bonds again.
The rates of interest offered by bonds, known as ‘yields’ were low when interest rates were also at rock bottom.
You can also 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.
How do you invest in bonds?
If you invest through a fund, the chances are that your fund manager will have at least a proportion of the funds in his or her charge invested in bonds. There are also specialist bond funds to consider.
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. Simply call us today
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 and returns of an investment are not guaranteed, investors may lose some or all of their investment. Capital is at risk.
The Financial Conduct Authority does not regulate taxation advice, and UK Government Securities.
Past performance is not a guide to future performance.
