Investing in bonds is clearly a popular investment class given there is over $100 trillion invested in bonds globally. How safe are bonds as an investment and what are the risks involved?
What is a Bond?
Governments and corporations issue bonds as a way to raise finance. In exchange for investing in bonds, the investor receives regular interest payments and the return of the principal amount at a specified date, known as the maturity date.
Bonds are known as fixed-income or fixed-interest securities because of these regular fixed payments.
There are short-term, medium-term and long-term bonds.
Investing in bonds can help balance your investment portfolio. Many equity investors also invest in bonds due to their lower volatility and regular fixed payments.
Equities are generally more volatile than bonds and may or may not pay dividends. If they do, the dividends are variable. In contrast, bond payments are fixed.
How Investing in Bonds Work
- Issuer – This is the government or corporation that issues the bonds. For example, the UK government wants to borrow £500 million. Therefore, it issues £500 million in securities. Typically the issuer will launch these at “par” or 100p in the pound.
- Coupon – This is the fixed interest payment, the bond coupon, that the issuer commits to pay you annually or semi-annually per year.
- Maturity – This is the set date, the maturity or redemption date, when the bond issuer will repay you, as the bondholder, the principal amount. The bonds will be redeemed at “par” or 100p in the pound (with some rare exceptions). However, if the issuer fails you might lose some or all of your investment and the income could stop.
Source: Hargreaves Lansdown
Return on a Bond
The yield is the return on the principal of the bond. There are various methods to calculate it such as the income yield, simple yield and yield to maturity.
Types of Bonds
Corporate Bonds
Corporate bonds: Companies issue corporate bonds to raise capital for their business. This funds activities such as research and development (R&D), takeovers, and refinancing and restructuring of corporate debt. Corporate bonds usually offer higher interest rates than government bonds as they are deemed higher risk. The company could get into financial trouble and be unable to repay the interest on the bond or repay the full price of the bond at the maturity date.
Junk Bonds have been rated below investment-grade bonds by credit agencies like Fitch and Moody’s. They offer higher interest rates to reflect the higher risk that they carry as the company issuing the bond may default on their payments.
UK Government Bonds
Government bonds are issued by a government to finance its spending and debt.
In the UK, these bonds are known as gilt-edged securities or gilts.
When the UK Government issues a gilt, it promises to pay the gilt investor a coupon every six months until the maturity date. At maturity, the holder receives the final coupon payment and the return of the principal. If the maturity date falls on a UK non-working day, then payments will be made on the next UK working day.
For example, an investor who holds £1,000 nominal of 1½% Treasury Gilt 2047 will receive two coupon payments of £7.50 each on 22 January and 22 July each year until the gilt reaches its final maturity date (in this case 22 July 2047). On the day when the gilt matures, the holder receives the repayment of the principal and the final coupon payment. Source: UK Debt Management Office
Index-linked gilts is where the semi-annual coupon payments and the principal repayment are adjusted in line with the UK Retail Prices Index (RPI) with a lag. This means that both the coupons and the principal repaid on redemption of these gilts are adjusted to take account of accrued inflation since the gilt was first issued.
U.S. Government Bonds
In the U.S., government bonds are known as treasuries. Treasuries with maturities of less than one year are called treasury bills, while those with maturities of one to 10 years are called treasury notes and treasury bonds have a maturity greater than 10 years.
Treasury Inflation-Protected Securities (TIPS) The US government issues TIPS for terms of 5, 10 or 30 years. They are indexed to inflation to protect you from inflation eroding the purchasing power of your money.
The principal of a TIPS goes up with inflation and down with deflation. TIPS pay interest on the adjusted principal, so although the rate of interest is fixed, the payments may vary.
When a TIPS matures, you get either the increased (inflation-adjusted) price or the original principal, whichever is greater. You never get less than the original principal. Source: TreasuryDirect.gov
Municipal Bonds are loans issued by state and local governments. They are used to fund improvements to public libraries, schools, bridges, roads, parks etc.
Global Government Bonds
You can find some of the yields offered by various governments across the world on a 10-year government bond here.
Bond Funds
You can invest in Bond funds that include corporate bonds and government bonds.
Some examples are provided below.
VANGUARD UK GOVERNMENT BOND INDEX INCOME (GBP)
This bond index is passively managed and tracks the performance of the Bloomberg U.K. Government Float Adjusted Bond Index (the “Index”). It includes investments in UK gilts with maturities greater than one year. It has an ongoing charge of 0.12% and pays a 2.69% yield quarterly.
From the chart below, you can see that the total return on this bond index starts to drop as the Bank of England starts increasing base rates.
ISHARES OVERSEAS CORPORATE BOND INDEX CLASS H – ACCUMULATION (GBP)
This fund is passively managed and tracks the performance of the ICE ESG Global Corporate Ex GBP Index (the Fund’s benchmark index). It invests in investment-grade corporate bonds issued by companies operating globally. It also seeks to exclude issuers which do not meet the index provider’s environmental, social and governance (ESG) ratings and criteria.
Advantages and Risks of Investing in Bonds
Advantages of Investing in Bonds
Some of the advantages include:
- Income: Bonds can provide a regular stream of income.
- Safety: Bonds are generally less volatile than stocks. The higher the creditworthiness of the bond issuer the less risk there is that the issuer will default on the interest payments and that they will repay the principal at mturity date.
- Variety: Investors can choose from different types of bonds, varying maturities, various risk ratings, sectors, and geographic regions of bonds.
Risks of Investing in Bonds
- Low returns: Bonds typically have lower returns than stocks over the long term, as they have lower growth potential and lower risk premiums.
- Inflation Risk: Inflation in the UK is currently 6.7%. If you invest in a bond paying, say, 4% interest, then inflation is eroding your income.
- Interest rate risk: There is generally, an inverse relationship between bond prices and interest rates. When interest rates rise, bond prices fall, and vice versa. Source: Finra Org.
- Credit risk: This is the risk that the bond issuer may default on coupon payments to the bondholder and may fail to repay the principal amount at the maturity date. The level of credit risk depends on the creditworthiness of the issuer. If the issuer has a poor credit rating, for example, a ‘C’, (AAA is low risk and C is highest risk) and is potentially at risk of default or bankruptcy, then the bond yield is higher to compensate for the risk of default.
In Summary
Bonds can provide a regular source of income and help diversify your portfolio. They are generally less volatile and less risky than shares. However, like all investments they do carry risk.
When choosing which bonds to invest in, whether that be government or corporate, do your due diligence and factor in your risk appetite and your investment goals.
Thanks for reading!
Have you invested in bonds? If so, share your experience in the Comments section below.
DISCLAIMER: Inquisitive Finance operates on principles of exchange of knowledge, ideas and opinions and learning in the community. Your decisions are entirely your own responsibility, and I am in no way responsible for your actions. I am not a financial advisor. Whilst I strive to provide accurate and up-to-date information, I make no warranties or representations as to the accuracy or completeness of this information. Use common sense, do due diligence and where necessary, use the services of a licensed financial advisor, before making any financial decision and/or transaction.
