Archived article

Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

We look at the world of fixed income and its pros and cons for investors

What are bonds and why investors might want to hold them in their portfolios? Whereas a share is literally just that, a share in the profit generated by a company, a bond is an ‘IOU’ which companies make to investors.

It typically carries a fixed rate of interest over a fixed period, say five or 10 years, and pays annual or semi-annual ‘coupons’ or interest payments. Because both these variables are usually fixed, bonds are often described as ‘fixed-income’ securities.

Once the bond reaches ‘maturity’ or its expiry date, the company which issued it is obliged to pay back the bondholder their initial investment in full.

How is interest paid?

Originally, bonds had detachable, individually-numbered coupons which investors would ‘clip’ and send to the issuer in order to claim their payment. A good example is US railroad bonds issued in the mid-1800s, or the Confederate State bond.

The bond was issued by the Confederate States of America in August 1863 with a face value of $1,000 and a 10-year lifetime, meaning it would be repaid in July 1873.

It carried an 8% rate of annual interest, and every six months the bond holder would clip the coupon and present it at their local bank in exchange for $40 of interest in cash.

When the bond matured in 1873, the bondholder would have expected to receive back their original $1,000 investment, though the defeat of the Confederate states in the American Civil War rendered this academic.

Today, if you own a bond the interest payments are made electronically into your account.

What is a yield?

Unlike shares, which are quoted on the basis of price, bonds tend to be bought and sold on the basis of their ‘yield’.

All bonds are issued at ‘par’, or 100% of their face value and they are also redeemed at face value assuming the issuer doesn’t go bust.

If a bond with an interest rate of 5% is trading at ‘par’, its yield is 5%. If the bond trades below ‘par’, the interest rate will be more than 5%, and if it trades above ‘par’ the interest rate will be below 5%. In practice, most bonds trade either above or below ‘par’ for most of their lives as markets rise and fall.

The last couple of decades has seen more and more investors buy bonds, which has meant that the interest rates companies have paid to issue bonds has been getting smaller and smaller.

It has also meant that yields on bonds have got smaller and smaller as more people compete to buy them, forcing prices up.

Who can issue bonds?

Companies can issue bonds, and so can governments and non-government organisations (NGOs) like the World Bank.

There is a clear pecking order in bond quality – reflecting the likelihood of getting your money back. Government bonds, known as gilts in the UK or treasuries in the US, have traditionally been seen as the most secure and as such are used to benchmark the bond market.

They are by far the biggest issuers and as long as they borrow in their own currency they should always, in theory at least, be able to print more cash to pay the coupon.

A rough guide to credit quality is provided by ratings agencies such as Standard and Poor’s (S&P), Moody’s and Fitch. S&P and Fitch both grade bonds in descending order from AAA to AA+, AA, AA-, BBB+ and so on.

Well-known international companies like GlaxoSmithKline (GSK) and Unilever (ULVR) are seen as likely to pay bondholders back and their bonds typically have quite low interest rates.

Companies which have poor financial situations, or which already have a lot of debt, typically need to pay much higher interest rates to compensate investors for the risk of buying their bonds.

The longer the period to maturity, the greater the return on the bond (at least in most cases).

This is compensation for the risk posed by the longer holding period. So, UK gilts which pay out after just a month offered a yield of 0.134% at the time of going to press while those with a 20-year term offered a yield of 0.7%. Price volatility also tends to be higher on longer-dated bonds.

What are the pros and cons of bonds?

One of the main advantages of bonds compared with shares is that if a company goes bust shareholders could lose all their investment. All shares entitle you to is a share of the profits.

Bonds are a claim on a company’s assets instead, so if it goes bust at least you stand a chance of getting something back.

Bondholders still tend to rank below the banks and trade creditors in terms of being paid, and the type of bond you hold determines how much of your money you might get back.

Another advantage of bonds is that they tend to be less volatile than shares, although the trade-off is that over the long term shares have performed better.

For individual investors investing in individual government and corporate bonds is not as straightforward as shares. Most investment platforms require you to invest in bonds over the phone rather than online and corporate bonds often have to be traded in denominations of £10,000 or more and are typically harder to sell than shares.

Alternatives are provided by funds and investment trusts which invest in fixed income and exchange-traded funds which track different baskets of bonds. These have the advantage of providing diversification too.

‹ Previous2020-04-16Next ›