Bonds: What They Do and How They Can Work for You

Bonds are loans made to a government or company and paid back with interest, offer regular income and can be income streams and a potential financial cushion during economic downturns.

Daniel Liberto Published on 16 December 2020. Last updated on 20 January 2021.

What are bonds?

Bonds are like IOUs. When you buy one, you’re basically lending money to a government or company for a fixed period of time in return for interest.

The money you lend is known as the principal, or face value. Over the course of the bond you receive regular interest payments, called coupons. And provided the institution doesn’t go bust, at the end of the agreed period you are paid back your principal.

» MORE: How to get started investing

How do bonds work

Investors don’t necessarily need to purchase a bond when it’s first issued and hold onto it until redemption. It’s fairly common to buy a bond secondhand, pocket its coupon, and then offload it to someone else before it expires.

The existence of a secondary market means investors can make money from bonds in two ways:

  1. From the income they pay.
  2. From speculating on their future worth and selling them at a higher price than they were purchased for.

The return a bond offers, and its subsequent perceived value, depend on a variety of factors, including:

  • The issuer’s credit rating. Like consumers, governments and companies are assigned a credit score by an external third-party based on their ability to meet financial commitments. Interest payments are usually highest on bonds with the lowest credit ratings because they are perceived to be a greater risk for investors.
  • Interest rates. When economic activity picks up governments often hike interest rates to keep inflation in check and discourage people from spending. Higher borrowing costs boost returns on risk-free saving accounts, reducing the appeal of older bonds in circulation and forcing companies and governments to fork out more to tempt investors to lend them money.
  • Inflation. Except for the odd index-linked bond, which adjusts coupon payments in line with the rate of inflation, most bonds pay a fixed rate of interest. That means a rise in the cost of living will lead the money you put up and earn from your investment to deteriorate in value, causing demand for old bonds to plummet and newly issued ones to be more generous.
  • Supply and demand. The return and price on bonds, or yield, can be influenced by how many buyers and issuers there are in the market. If lots of institutions need to borrow money, investors can be pickier, and vice versa.
  • Duration. Bonds are generally classified as either short-, medium- or long-term, depending on the time they take to mature and pay back the money owed. Longer wait times are usually accompanied by better compensation.

Types of bonds

There are several types of bonds available to UK investors. The most common:

  • Government bonds. IOUs issued by a government to support their spending and obligations. Two examples are Gilts (UK government bonds) and Treasuries (US government bonds).
  • Corporate bonds. Companies ask people to pool together money for a loan and then aim to repay what they owe from their earnings and cash flow.

Pros and cons of investing in bonds

Pros

Bonds come with several potential benefits. One that's attractive to some investors are the steady, regular interest payments that supplement their income.

Another is that bond and share prices historically tend to react differently to changes in the economic cycle. Because they generally move independently of each other, an investment portfolio that holds both is likely more balanced and less prone to shed significant value.

» MORE: How to buy shares

Cons

Bonds, like any other asset class, aren’t perfect. People mistakenly describe bonds as safe, straightforward investments. What they might fail to mention is that long-term bonds with high yields can be just as volatile as shares – and that when economic downturns are forthcoming, periods when their coupon payments become more appealing, issuers are likely to be more strapped for cash and at a greater risk of defaulting.

How to buy bonds

It generally pays to buy bonds through a Stocks and Shares ISA or, for retirement purposes, a self-invested personal pension (SIPP). Most platforms offer both of these tax-free shelters and a wide selection of bonds to choose from. Gilts, the name for UK government bonds, are issued in £100 units, with some lasting just a few years and others for several decades. Corporate bonds, too, can be purchased in relatively small increments, thanks to the arrival of retail versions designed specifically for ordinary investors.

However, as with shares, it could make sense to choose a fund. A bond fund pools investors’ money and invests it in a variety of holdings. In addition to investing in a wider range of bonds than you would by going it alone, you are spared the difficult decisions around which ones to buy.

» MORE: Investment platforms explained

Fees for bond funds vary depending on how actively they are managed and the types of bonds they invest in. Some funds focus on a specific area, while others, such as strategic bond funds, invest across the entire market.

» MORE: What you should know about investment funds

Before choosing which bonds to invest in, consider the following:

  • Don’t take credit ratings at face value. Ratings range from AAA, for companies viewed as the least likely to default on their loan repayments, all the way down to C or D, and these ratings are reviewed every six to 12 months. But you should scrutinise the issuers’ financial health yourself, thinking about your risk tolerance and remember that bonds offering high yields do so for a reason.
  • Read the prospectus, including the small print, for a full breakdown of what your investment entails.
  • Evaluate how inflation will affect the value of your investment and the likelihood of the economy strengthening and interest rates rising.

WARNING: We cannot tell you if any form of investing is right for you. Depending on your choice of investment your capital can be at risk and you may get back less than originally paid in

About the author:

Daniel is a freelance finance journalist. He has written and edited news, deeper analysis features, and opinion pieces for the Financial Times, Investopedia and the Investors Chronicle. Read more

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