Of the various types of investment, bonds are typically more secure and less volatile than equities (stocks & shares). Their medium-risk status makes them an important halfway house between low-growth cash and high-risk shares, so they can provide a relatively stable source of growth for an investment portfolio.
Bonds are issued by both governments and corporations, and as such not all bonds are made equal. Some are more risky than others, while offering great potential for returns. Here are some initial pointers for getting into bond investment, and how to use bonds as part of your overall investment strategy.
Step 1 – Understanding how bonds work
A bond is essentially a loan. In this case, you are the lender, and the borrower is the country or corporation that issues the bonds. When you buy a bond, you lend the issuer your money, and they pay you back with interest.
For this reason, bonds are known as ‘fixed income securities’, because you know how much you will receive in return for your investment. As the lender, you are paid back in full at the bond’s ‘maturity date’. You are also paid interest at regular intervals, in what is known as a ‘coupon’. The rate of interest varies from bond to bond, with riskier bonds generally offering higher potential returns (but more risk of not getting your investment back).
Government bonds are called gilts, and allow governments to borrow money to finance public spending. Corporate bonds allow companies to grow their business or undertake new projects by raising more funds than a bank might be willing to loan them.
Step 2 – Understanding the factors that move the price of bonds
The price of bonds and the bond yield (the return on your investment) is affected by a number of factors. Supply and demand both impact the price of bonds, and the availability of government bonds is driven by the health of the global stock market. When stock markets are experiencing a period of rapid growth, many investors will move their funds into stocks to capitalise on the boom. As a result, demand for bonds goes down, as they do not offer the quick rewards that day trading can.
However, once the boom subsides, or if serious economic problems seem imminent, bonds become more appealing. They’re considered a safe haven for investors’ cash, so will rise in price. However, as government spending increases – to support increased numbers of unemployed people following a recession, for example – it will need to issue more bonds to support itself. As a result, bond prices will come down again. Prices can therefore fluctuate like ocean waves – the investor may sometimes have to think like a surfer, waiting to catch the right one.
Changes in a government’s monetary policy will also affect the price of bonds, for example if a country’s central bank alters its base interest rate. If new bonds are issued with a higher interest rate, the resale price of existing bonds will go down. This decrease in value means you’ll generally have to accept a loss if you want to sell your bond to another investor before it reaches maturity. This relationship works the other way too – you’ll be able to sell your bonds to other investors for a higher price if the interest rate of new bonds isn’t as high.
Step 3 – Learn about the different types of bonds
Of the various types of bonds, the most important categories are government bonds and corporate bonds. Government bonds are a good option if you’re looking for stable domestic or international investments, while corporate bonds may suit you if you want to take a bit more risk in exchange for higher potential growth.
Municipal bonds are another option. These are issued mainly by local governments and non-profit organisations, so some types might suit those who are seeking ethical investments. They can take the form of a general obligation bond (where your investment isn’t linked to a specific project), or a revenue bond (which pays your interest via sales or donations, for example).
Yet another type is agency bonds, which are issued to government-sponsored enterprises. Agency bonds can offer higher interest rates, although this is because they’re less liquid and secure than government bonds.
You can also hedge against the impacts of inflation by purchasing inflation-index-linked bonds (ILBs). These bonds will increase in value if inflation rises, while regular bonds will offer lower real returns. However, their value could also decrease if an economic crisis results in negative inflation (also known as deflation).
If you’re seeking something with higher rewards and risk, you might look at callable bonds. With this kind of agreement, the issuer (or borrower) has the right to pay off their bond before it reaches maturity. The principle of a callable bond is the same, but there will be a ‘call option’ in your agreement. To make this type of bond more appealing, issuers offer higher interest rates, on the understanding that there is a risk of having the bond paid off early, so you lose out on future interest.
Step 4 – Understanding the risks of investing in bonds
Most government bonds are considered low-risk investments, as governments (at least of stable countries) aren’t likely to default on their loan payments to bond holders. The risk is never zero, though, as a seemingly functioning economy could hide deep-rooted economic problems – Greece’s 2015 debt default is a prime cautionary tale. Corporate bonds are riskier than government bonds, but they’re usually safer than equities as you’ll receive guaranteed annual coupon payments.
To determine the risk level of a bond, look at its rating with the credit ratings agencies: Moody’s, Standard & Poor’s (S&P) and Fitch. The higher the rating, the more secure the bond is – look for the term ‘investment grade’ if you’re not sure, as it means the bond is unlikely to default. Triple-A (AAA) is the most secure you can buy.
Anything rated BB+ or below by S&P and Fitch, or Ba1 and below by Moody’s, is considered a ‘junk bond’. This means there’s a real possibility that the bond holder will default and not repay your investment. However, junk bonds can still offer great returns if you get lucky, as they will generally offer much higher interest rates to offset the risk and encourage investors to purchase. You just have to hope that they don’t default, in which case your investment is lost.
Step 5 – Seek professional financial advice
It’s always best to speak to an independent financial adviser (IFA) before investing in any kind of bonds. They will be able to go through the investment risks with you and advise which bonds match your long-term financial goals. Even though this investment option is considered lower-risk and relatively simple for new investors, it still makes sense to seek advice before placing your money in someone else’s hands.
An IFA is also completely impartial, meaning they can help you assess what’s right for you without any pressure to go ahead. As a result, they will guide you towards a bond option that genuinely fits your risk appetite and desired return, rather than pushing you towards something unsuitable because of commission or a vested interest.
Step 6 – Work out if investing in bonds matches your investment goals
Bonds are a great option if the unpredictability of the stock market doesn’t appeal to you as, with most bonds, you’ll know what your return is from the start. You could also explore the secondary market and purchase bonds that others are selling, which can net you a bargain investment. You may not make as much money as you could have if new bonds are issued with higher interest rates, but you don’t stand to lose a lot either.
Investors that are comfortable with more risk could look into callable bonds or ILBs. These options are still comparatively low risk next to an option like individual stocks, but offer the potential for greater returns on your investment. If you’re not looking for instant returns, and favour stability and security over endless growth potential, bonds are likely to suit you.
Step 7 – Invest in government and/or corporate bonds
You can choose your own bonds using an execution-only brokerage, if you have a good idea of the right bonds for you. If you choose to DIY your investment, you won’t receive any advice or guidance from a stockbroker. As a result, the fees for these platforms are often very low, making them an affordable way to begin investing.
However, if you’ve never invested before, it’s always best to speak to an IFA first. You’ll receive impartial advice about which bonds you should invest in and, if bonds make up part of a wider portfolio, can leave the hassle of managing your investments with them. The costs will be offset by the peace of mind you’ll enjoy from knowing you’ve made a smart investment choice.