What is a bond?
A bond is effectively a way of lending money to companies or governments. In return, they pay you a regular income in the form of interest for a set period of time, after which they must repay your loan.
Bonds are sometimes called fixed-income investments, as repayments were traditionally fixed, though bond rates can also be variable. UK government bonds are also known as ‘gilts’.
Here, we explain how bonds work, what kind of returns they might offer you, the risks you might encounter, how to invest and what role fixed income assets might play in your investment portfolio.
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Why invest in bonds?
If you want a better return than you can get on your cash savings, you will need to accept greater risk.
Fixed-income investments are generally considered the next step up from cash and tend to be less risky than shares.
They are designed to pay you a steady income and tend not to offer opportunities for capital growth – at least, not in normal economic times.
The most common forms of fixed-income investment are:
How do bonds work?
A conventional UK gilt might look like this:
3% Treasury stock 2030
Here’s what the various elements mean:
- 3% – the coupon rate. This indicates how much you’ll receive per year, generally paid in 6-monthly installments.
- Treasury stock – who you’re lending to. For corporate bonds, you’ll find the company’s name here i.e. Tesco PLC 4% 2018.
- 2030 – the redemption date, when you’ll get the principal (your original investment) back.
Returns from gilts and corporate bonds
If you buy £1,000-worth of Treasury stock 2% 2025 gilts, you would receive 2%, or £20, every year until your £1,000 loan is repaid in 2025. The income you receive is called the ‘income yield’, ‘running yield’ or ‘interest yield’ and is paid twice a year (1% or £10 every six months, in this instance).
The coupon rate is determined by the length of time you must wait for maturity and/or the riskiness of the company within which you invest.
The further away the redemption date, the higher the interest you will receive, as you are having to wait longer to be repaid. Similarly, the greater the risk you take on a company, the higher the interest rate you can expect to receive.
Unlike shares, they don’t give you a stake in the company, but make you a creditor, ranking above shareholders in the pecking order if the company becomes insolvent.
You may not get your full investment back in the case of insolvency – only a proportion of the assets that are left.
You’re not covered by the Financial Services Compensation Scheme, so it is important to assess the strength of the business you are lending to.
What is the ‘redemption yield’ of a bond?
The redemption yield is a rate of return that combines the interest rate you get based on the price at which you buy the gilt, government bond or corporate bond, and the profit or loss you get if you hold the bond to maturity.
If you bought a gilt, government bond or corporate bond at a price that’s lower than the launch price (£100), the redemption yield will be higher than the running yield, as you’re set to make a profit when the bond matures.
Conversely, if you bought a gilt, government bond or corporate bond at a price that’s higher than the launch price (£100), the redemption yield will be lower than the running yield, as you’ll make a loss if you hold the bond to maturity.
Green gilts and green corporate bonds
Green bonds work just like any other corporate or government bond.
Essentially, the funds that would be raised through green bonds would have to be directed to renewable energy and clean energy projects.
In September 2021 the UK began issuing Sovereign Green Bonds (or ‘Green Gilts’).
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What do credit ratings of bonds mean?
Gilts, government bonds and corporate bonds are given credit ratings by companies, such as Standard and Poor’s, and Moody’s.
Gilt, government bond and corporate bond credit ratings
This table shows the Standard and Poor’s ratings on gilts, government bond and corporate bonds, along with what they can tell you about the health of a particular company or government bond.
Getting to grips with the issuer of a bond and its rating is key to understanding how you can make money from bonds.
As with all investments, the greater the risk you take, the greater potential return you could make. Inevitably, this also comes with greater potential for loss.
How do I buy bonds?
There are two main options if you want to buy fixed-income investments – you can invest directly in individual bonds or you can invest in collective investments such as unit trusts.
Direct investment in gilts and corporate bonds
You can buy UK government gilts directly from the UK Government’s Debt Management Office (DMO). However, to buy directly from the DMO you need to apply to join an approved member list.
You can buy corporate bonds from the London Stock Exchange’s Retail Bond Platform. They require a minimum investment of £1,000.
You can also buy gilts and corporate bonds through a stockbroker or fund investment platform.
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Gilts and corporate bonds on the secondary market
Most gilts, government bonds and corporate bonds are traded on a secondary market, and their value can fluctuate based upon interest rates and the solvency of the issuer.
Bond prices will rise when general interest rates are low, because the rates of interest they pay are fixed and will beat the short-term rates available from banks.
Therefore, you may buy a bond or gilt for an amount above or below its original value (nominal value), and this will have an impact on both how much interest you receive as an income and the amount of money you will receive when the bond matures.
It works like this:
- If, for example, you paid £95 for a gilt, government bond or corporate bond with a nominal value of £100, you will make a capital gain when it matures, as the loan is repaid at the nominal value.
- Similarly, if you bought the gilt, government bond or corporate bond for £105, you would lose out on maturity, as you’re only paid back at the nominal value.
- The amount of interest you’ll receive will also change dependent on the price you paid. If you buy a bond or gilt paying 6% for, say, £95, the effective interest rate you’ll receive is higher than 6% as interest is paid on the nominal value, not the second-hand market price you paid.
- In this example, the rate you receive is actually 6.32% (i.e. 6/0.95 = 6.32).
Investing in bond funds
Bond funds are collective investments, such as unit trusts or open-ended investment companies (Oeics). These funds pool your money with other investors’ and invest it in a broad range of gilts or bonds.
Unlike direct investment, there is no maturity date with bond funds. The manager invests in dozens, or even hundreds or different bonds or gilts.
By investing in multiple bonds within a fund, you are able to spread risk. You can expect to pay an annual charge of between 0.5% and 1% for investing through a corporate bond or gilt fund, or much lower if you choose a corporate bond or gilt-tracker fund.