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What is a Bond?

Bonds are back in favour with investors but they are often seen as harder to understand than shares - how do they work and role can they play in an investment porfolio?

James Gard 11 November, 2019 | 9:13AM

Pounds

Bonds are a popular choice among income-seeking investors, but they can be more complicated to understand than equities. But it's worth taking the time to get your head around the asset class and how bonds can benefit your investment portfolio. 

What is a Bond?

Companies and governments raise money by issuing bonds and they attract investors looking for income and some degree of capital security. Governments use the money for public spending on health, education and defence, for example, and firms issue bonds to fund projects and acquisitions.They could be seen as "IOUs" on a grand scale - you lend your money and, at the end of an agreed period, you should get it back in full. 

Bonds are seen as less risky than equities and have historically held up well in the face of stock market volatility. UK government bonds, or gilts, for example, are seen as “risk-free” in that the chances of the UK defaulting are minimal. While bonds are seen as poor relations in investment terms to equities over the very long term, there are some environments in which they are the best performing asset class. That because, the price of a bond rises and falls in line with supply and demand too, so there can be capital gains to be had. In the last 20 years, despite a very prolonged bull run for shares, bonds have outperformed.

One perk of holding corporate bonds is that they rank higher than ordinary shareholders if a company goes bust – in the case of Thomas Cook, for example, owners of its shares on the last day of trading were wiped out, but bondholders will receive some (though not all) of their money back.

Understanding Bonds

Investors often prefer shares over bonds because they are perceived as easier to understand. Certainly there are more variables to take into account when investing in bonds – for example if you hold them to maturity the returns are different than if you sell before the bond matures. Inflation, interest rates, economic growth and ratings agencies all have an impact on bonds.

But there are some very straightforward aspects to bonds – when their prices rise, their yields fall and vice versa. Higher demand for bonds pushes up their prices and, as a result, yields fall (this is similar to equities, where a dividend yield falls as a share price rises). Unpopular bonds, such as Greek government debt during the 2012 crisis, had very high yields to reflect the risk investors were taking that the government would default.

Bonds are often referred to as “fixed-income securities” because the pay a fixed coupon. If a UK Government bond has a “maturity” of 2029, paying 1%, that means that you will receive 1% on your investment for 10 years, usually paid twice a year. An equity investor, in contrast, is subject to the fortunes of a business: one year shares may pay a dividend yield of 5%, but the company could scrap its dividend the following year.

Bond investors often trade off that security for a lower but more predictable yield if they need to meet particular liabilities. This often suits pension funds, for example, which know they must pay out fixed sums to pensioners at set dates.

Long-term government bonds help pension funds make payments because they know they will get a predictable income stream and they will get their money back at the end of the holding period.

An investment in a share is far less predictable – the company could be like Amazon – whose share price has gone from $100 to $1,774 in 10 years – or like Thomas Cook, whose shares crumbled to nothing this year. A pension fund relying on a Thomas Cook share to pay retirees would be left empty-handed over 10 years and would leave its pensioners impoverished. Not only would they have failed to meet the income payments, their capital would have been destroyed.

What often puts investors off is the complexity of bond pricing and how that determines how much money you make. Bonds often trade above or below “par value”. If you buy a bond above its nominal value and hold that to maturity, you are guaranteed to make a capital loss – for example a £100 bond might be trading at £150 three years before maturity, but if you hold it to maturity you will still only get £100 back. In reality, bonds are traded between issue and maturity and capital values go up and down.

How to Buy Bonds

While direct investing in bonds is less popular than equities in the UK, it’s still possible to buy government and corporate bonds. 

Corporate bonds for large companies like Tesco are easily tradeable through stockbrokers and can be held in Isas and Sipps. Government bonds can also be bought through mainstream platforms, but whether you'd want to is debatable: a 2% Treasury bond that matures in 2025 is selling for £109, which means you have to pay £109 for a bond that will pay you back £100 in six years. A 50-year gilt pays 3.5% but you'd have to pay £193 now, and wait 50 years to get £100 back. If you need 3.5% income over 50 years, than this would be a suitable investment, but you are paying a hefty price for this security.

Most UK investors prefer bond funds to direct investing, not least because the complexities of the bond market tends to favour professional investors. But bond funds are also less risky than owning a bond directly yourself because they spread their risk against many different bonds, often of different maturities and issued by different entitities. 

There are plenty of active and passive options for investors. Vanguard has just slashed fees on its fixed-income offerings, so costs are coming down every year, although bond index funds are generally more expensive than stock market trackers.

The fall in yields across the developed world in recent yields, to in some cases negative interest rates, means that investors have had to look further afield for income. Emerging market bond funds, both active and passive, have grown in popularity.

Morningstar’s highest rated bond funds, with a Gold analyst rating and five-star performance rating, are Robeco High Yield Bonds, HSBC Euro High Yield Bond, BlackRock Euro Bond Fund.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

James Gard  is content editor for Morningstar.co.uk

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