What are bonds and how do they work?

When most people think of bonds, it's 007 that comes to mind and which actor they have preferred over the years. Bonds aren’t just secret agents though, they are a type of investment too.

What are bonds?

In simple terms, a bond is loan. When you buy a bond you are lending money to the government or company that issued it. In return for the loan, they will give you regular interest payments, plus the original amount back at the end of the term.

As with any loan, there is always the risk that the company or government won't pay you back your original investment, or that they will fail to keep up their interest payments.

Investing in bonds

While it is possible for you to buy bonds yourself, it's not the easiest thing to do and it tends require a lot of research into reports and accounts and be quite expensive.

Investors may find that it's much more straightforward to buy a fund that invests in bonds. This has two main advantages. Firstly, your money is combined with investments from lots of other people, which means it can be spread across a range of bonds in a way that you couldn't achieve if you were investing on your own. Secondly, professionals are researching the entire bond market on your behalf.

However, because of the mix of underlying investments, bond funds do not always promise a fixed level of income, so the yield you receive may vary.

There are hundreds of bond funds available in the UK, so choosing one can be a difficult and daunting task. That's where Chelsea can help. We have the Chelsea Core selection and Chelsea Selection lists, which contain bond funds the Chelsea research team believe to be the best of breed.

Learning the lingo

Whether you are choosing a fund or buying bonds directly, there are three key words that are useful to know: principal; coupon and maturity.

The principal is the amount you lend the company or government issuing the bond.

The coupon is the regular interest payment you receive for buying the bond. It is often a fixed amount that is set when the bond is issued and is also referred to as the 'income' or 'yield'.

The maturity is the date when the loan expires and the principal is repaid.

The different types of bond explained

There are two main issuers of bonds: governments and companies.

Bond issuers are normally graded according to their ability to repay their debt, This is known as their credit worthiness.

A company or government with a high credit rating is considered to be 'investment grade'. This means you are less likely to lose money on their bonds, but you'll probably get less interest as well.

At the other end of the spectrum, a company or government with a low credit rating is considered to be 'high yield'. As the issuer has a higher risk of failing to repay their loan, the interest paid is usually higher too, to encourage people to buy their bonds.

How do bonds work?

Bonds can be sold on and traded – just like a company's shares. This means that their price can go up and down, depending on a number of factors.

The four main influences on bond prices are: interest rates; inflation; issuer outlook, and supply and demand. 

Interest rates

Normally, when interest rates fall so do bond yields, but the price of a bond increases. Likewise, as interest rates rise, yields improve but bond prices fall. This is known as 'interest rate risk'.

If you need to sell your bond and get your money back before it reaches maturity, you may have to do so when yields are higher and prices are lower, which means you would get back less than you originally invested. Interest rate risk decreases as you get closer to the maturity date of a bond.

To illustrate this, imagine you have a choice between a savings account that pays 0.5% and a bond that offers interest of 1.25%. You may decide the bond is more attractive.

However, if the Bank of England raises interest rates and banks follow suit, the savings account may now offer 2%. Suddenly the 1.25% the bond is paying isn't so appealing and its price is likely to fall.

Inflation

Because the income paid by bonds is usually fixed at the time they are issued, high or rising inflation can be a problem, as it erodes the real return you receive.

As an example, a bond paying interest of 5% may sound good in isolation, but if inflation is running at 4.5%, the real return (or return after adjusting for inflation), is only 0.5%. However, if inflation is falling, the bond may be even more appealing.

There are such things as index-linked bonds, however, which can be used to mitigate the risk of inflation. The value of the loan of these bonds, and the regular income payments you receive, are adjusted in line with inflation. This means that if inflation rises, your coupon payments and the amount you will get back go up too, and vice versa.

Issuer outlook

As a company's or government's fortunes can either worsen or improve, the price of a bond may rise or fall as a result of their prospects. For example, if they are going through a tough time, their credit rating may fall. The risk of a company not being able to pay a yield or being unable to pay back the capital is referred to as 'credit risk' or 'default risk'.
If a government or company does default, bond investors are higher up the ranking than equity investors when it comes to getting money returned to them by administrators. This is why bonds are generally deemed less risky than equities.

Supply and demand

If a lot of companies or governments suddenly need to borrow, there will be many bonds for investors to choose from, so prices are likely to fall. Equally, if more investors want to buy than there are bonds on offer, prices are likely to rise.

This guide was written with the kind help of M&G Investments