Investing in bonds explained
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There are many kinds of investment options to consider if you want to grow your money, with everything from peer-to-peer lending to securities in commodities such as fine wine, widely available to those looking to make their money work for them.
One of these options is investing in bonds, which people have been doing since as early as 2400 BC. To start investing your money in bonds, it’s important to first have an understanding of what exactly bonds are and how they work. We’ve explored this, as well as how to buy bonds, on this page.
What are bonds?
Put simply, bonds are an IOU. When you buy bonds, an institution, such as the government, or company is effectively borrowing money from you with an obligation to pay it back with interest.
Most bonds involve two types of payments. One of them is the lump sum payment made on the ‘maturity’ of your bonds, and the other is a series of smaller payments, or ‘coupons’, which are a fixed percentage of the lump sum.
Bond terminology explained
While the world of investing can be pretty complex, bonds are actually one of the easiest types of investment to understand – you just need a basic grasp of frequently used terminology.
- Issuer: This is the institution or company borrowing the money and therefore issuing the bond. For example, an institution could borrow £10,000 from you in exchange for 10,000 bonds.
- Coupon: The issuer commits to paying an agreed rate of interest per year, known as a coupon. This is usually a fixed rate, which means you can calculate the interest you would earn before committing to buying bonds.
- Secured/unsecured: Bonds can be secured or unsecured. Much like different types of debt, a secured bond pledges available assets to you should the company or institution you’ve invested in collapses. An unsecured bond, on the other hand, poses much more risk, as you will get very little or nothing in the event of a collapse.
- Maturity: This is a date set for when the bond ‘matures’, and therefore should be fully paid off by the issuer.
- Par: Depending on how your bond trades on the stock exchange, it will either be above par, on par or below par. For example, if you invested £1,500 into bonds and they are trading at £2,000, it will be above par. If they are trading for £900, they are below par, and so on.
Types of bonds
The particular type of bond you’ll get is usually determined by who is selling them. The two most common types of bonds in the UK are corporate bonds and government bonds.
Corporate bonds
Corporate bonds are used by businesses to fund things such as growth and development, investments and takeovers. Corporate bonds can be a good investment if the issuer has strong commercial and financial health. To properly determine whether a corporate bond is a good investment, you should weigh up the rate of return or ‘coupon’ alongside things like cash flow and liquidity.
Government bonds
Also known as ‘gilts’, government bonds are attractive in terms of their low risk, but don’t usually offer as competitive a rate of return as corporate bonds. Selling government bonds frees up money for the government.
How are bonds different to stocks?
While stocks offer you a stake, or share, in a company, a bond is a loan that provides a fixed rate of interest. When the bond matures, the company you’ve invested in will repay you, meaning there is no longer a connection. A shareholder, on the other hand, owns a piece of the company.
How does investing in bonds work?
Investing in bonds works in a similar way to taking out a loan. For example, with government bonds, you’re effectively lending money to the government. If you purchase £10,000 worth of bonds, you’re giving the government that money so they can use it to spend on whatever they need.
For example, take the below bond.
The price for one bond is £108.530. This is the amount you’d be loaning to the Treasury if you bought one bond. The interest rate is 1.625%, which is what you would receive each year as your coupon. This bond lasts for seven years, reaching maturity on the 22nd October 2028.
Therefore, you can calculate that:
1.625% of 108.53 = £1.76
This means you’ll be paid £1.76 each year as a coupon, earning a total of £12.32 in coupons by the time your bond matures.
Obviously, it’s unlikely that you would only buy one bond, but this illustrates how investing in bonds works.
Bond yield explained
The ‘yield’ of a bond is simply the rate of return you get on that bond.
When you buy a bond at par (i.e. paying the bond’s face value), the yield is equal to the bond’s coupon or interest rate. However, if you buy a bond at a discount or below par, your yield will be higher than the original coupon rate, while if you pay above par it will be lower.
For example, regardless of what you pay for any value of bond, you’ll still be earning the same coupon amount, and the rate of yield will change accordingly. As shown above, the calculation for this is the annual interest/coupon amount divided by the price you pay for the bond, times 100.
What factors influence bond yields?
Like anything else when it comes to investing, bond yields are ultimately determined by the base rate set by the Bank of England. This means when interest rates are low, bond yields will also be low.
How risky is investing in bonds?
Investing in bonds brings about some risks you’ll want to consider before you commit, including the following:
- Inflation risk – If the rate of inflation outpaces the fixed amount of income a bond provides, you stand to lose purchasing power over time.
- Time risk – When you buy a bond, you’re tying your money up for the duration of the bond, and you won’t have access to your cash until the bond matures.
- Interest rate risk – When interest rates rise, bond prices fall, and the bonds you hold can lose value. Fluctuations in the interest rate is one of the biggest reasons for price variability in bond markets.
- Financial risk – Credit risk (also known as business risk or financial risk) is the possibility that an issuer could default on its debt obligation. This risk is greater if you invest in unsecured bonds.
- Selling risk – Also known as the liquidity risk, the selling risk is the possibility you might wish to sell a bond but are unable to find a buyer.
You’ll also need to consider your own appetite for risk when deciding whether or not to invest in bonds, but they are generally a safer option than choosing to trade in stocks, since there’s typically less fluctuation in value.
To help you further determine the risk of buying bonds, you can look at the credit rating of a company or the bond itself.
Fixed interest credit ratings explained
- Rating: AAA
Grade: Investment Grade
Riskiness: Highest quality - lowest likelihood of default
- Rating: AA
Grade: Investment Grade
Riskiness: High quality - very low likelihood of default
- Rating: A
Grade: Investment Grade
Riskiness: Strong - low likelihood of default
- Rating: BBB
Grade: Investment Grade
Riskiness: Medium grade - medium likelihood of default
- Rating: BB, B
Grade: High Yield
Riskiness: Speculative - high risk of default
- Rating: CCC, CC, C
Grade: High Yield
Riskiness: Highly speculative - high risk of default
- Rating: D
Grade: High Yield
Riskiness: Default - unable to pay back debt
What is the best way to compare bonds?
The best way to compare bonds will ultimately be down to your personal preferences and appetite for risk. If you’re looking for bonds that will produce the highest return, you might want to filter your search for those with the highest interest rates and calculate the yield that you can expect to earn by the bond’s maturity date.
How to invest in bonds
Wondering how to buy bonds in the UK? You can sometimes buy government bonds, or ‘gilts’, directly from the government website through a Debt Management portal. The minimum amount you can invest is £100, with terms starting at just two years. Alternatively, when the government wants to issue bonds in the UK, it will normally do so via a bond auction. When this happens, bonds will typically be bought by a large bank or other financial institution that will then sell them on.
If you want to know how to buy corporate bonds, they are mostly traded on a secondary market and so can be bought from stockbrokers. However, this sometimes makes it difficult to ascertain what a fair price for corporate bonds is.
Pros & cons of investing in bonds
Advantages
- Diversification: Any experienced investor will tell you that you need to diversify your portfolio in order to mitigate risk. Bonds can be a great option for offsetting the risk of some of your other investments.
- Relative safety: Due to the high likelihood that you’ll recover all of your capital, particularly if you buy gilts, investing in bonds is typically a safe option for investing.
- Income: The benefit of receiving a coupon either annually or bi-annually is that you’ll enjoy regular income from your bonds.
Disadvantages
- Low returns: The return on bonds is often small, especially on those with lower risk.
- Interest rate risk: As with most investments, the value of a bond will depend largely on the current interest rate.
- Your money is locked away: When you buy a bond, you are agreeing to lock your money away and will only recover it fully on your bond’s maturity date.
- Bond market transparency: As most bonds are sold on a second market, brokers can sometimes charge more than the bond is worth to make a profit.
- Lower earnings than stocks: While they offer less risk, bonds don’t typically earn you as much money as investing in stocks and shares.
7 things to consider when investing in bonds
Investing in bonds might seem overwhelming, but it can be broken down into a few essential steps.
- Before you commit your money to a bond, ensure you know its maturity date and are certain you won’t need access to your money during this length of time.
- If you’re opting to use a bond broker as part of the process, ensure they are regulated by the Financial Conduct Authority (FCA). You should also ask them about their fees and commission.
- Ensure the bond has a credit rating of C and above. Anything below this is at a high risk of defaulting. Refer to the credit ratings table if you need help.
- Do your research into the company – particularly where cash flow is concerned – if you’re buying corporate bonds. You might also want to consider researching what the company invests in if you’re trying to invest ethically.
- Understand your risk appetite. Don’t make an impulsive decision based solely on a high predicted yield.
- Diversify your investments across your portfolio.
- Read the small print – you need to be aware of any terms and conditions, especially if they might cost you money.
Other ways to invest your money
Thinking about other types of investments? Find out everything you need to know about investing your money with our handy investment guides, which provide all the information you need to invest in the stock market.
Alternatively, if you’ve decided that investing poses more risk than you’re happy to tolerate, you could put your money into savings accounts which offer competitive rates of interest, such as fixed rate bonds.