Beginners guide to investing in bonds

Investing in bonds is something people often consider, but can also view as too difficult for beginners to get to grips with. Breaking the subject down and looking at it piece by piece, however, it is possible to see it is a process that is fully manageable, and one that has the potential to provide fantastic returns for those willing to embrace it.

What are investment bonds?

Bonds can appear complex and daunting, but in reality, the premise is relatively simple. When you buy a bond you are investing in a business, company or the government for a specified time period. At the end of this time, you receive your money back alongside an amount of interest. The process is subject to elements of risk, however, with the most immediate being the possibility of any company you have purchased bonds in folding before you are repaid, especially should the length of the loan period be expansive. Levels of interest, inflation, the general economic climate and many other facts are also prescient, with the general rule being that the price of the bonds will reflect the risk you are being subjected to.

Factors to consider
Thinking carefully about the variables that are involved when purchasing any bonds is essential, and lowers your chances of making any decisions that you later feel have been wrong for you. Spending some time thinking about possible outcomes and looking at how they might differ depending on certain elements, forms part of being knowledgeable about bond trading.

Time

Thinking carefully about the variables that are involved when purchasing any bonds is essential, and lowers your chances of making any decisions that you later feel have been wrong for you. Spending some time thinking about possible outcomes and looking at how they might differ depending on certain elements, forms part of being knowledgeable about bond trading.

Issuer

Who is borrowing your money is a consideration applied to any sort of financial transaction, with investment bonds being no exception. Looking at whoever is asking for the money, known as issuing the bonds, provides information as to the risk the money may be in. If the issuer is a trusted and established name, with a solid history that can be seen and assessed then returns should reflect this. Likewise, if they are unknown, or have a negative history, the returns should reflect the enhanced risk any money may be at. Issuers fall into two brackets; government and corporate. Research in this area is easy to do and highly recommended.

Interest rates

Spurred on by high growth and high inflation, raises in interest rates, sometimes referred to as coupons, are pivotal to bond investors, and can be problematic, due to returns becoming less. When investing in corporate bonds, a spread will usually reflect the increased risk over investing in government bonds, due to their subjectivity to various elements of cash flow and earnings that the latter is not. This spread will be based on the standing of the company, with the lower end being the most trusted. The interest rate will come as a fixed percentage of the bond, meaning that the rate will stay the same for the duration of the bond. If the bond terms stated, for example, a 5-year term on an interest rate, or coupon, of 5 percent, this would not alter. The riskier the bond, the higher the fixed interest rate should be, making it something worth looking carefully at.

General economic environment

Many factors of the economy also play into investment bonds, and impact on various aspects. A healthy economic environment will mean that spreads, as mentioned above, will be lower for instance, due to the lessened likelihood of a company going bust. Over the long term, however, this can cause problems as companies look to borrow more, increase their investments and potentially buy back shares, which can lead to future difficulties. A good economic environment that leads to higher returns on savings can also mean that investment in bonds may be something that drops altogether, as potential investors look to the interest on their savings instead. An economic downturn can be good news for the world of bonds, as prices rise and yields fall. 

Types of bond

Many different types of bond exist, within two major categories; government and corporate. The former, referred to as gilts, are viewed as much more safe by their very nature. The government is seen as far less likely not to return money as a result of financial difficulties; however, the returns on your investment are significantly smaller than corporate bonds. 

Gilts are available at an initial value (known as par, or face value) when first made available, but are also possible to obtain at a later period at whatever their current market rate is deemed to be. As they repay at the par value, this can enhance risk if they have been purchased at a price over par. It is also possible to sell them at any point at the market value, should you wish. Corporate bonds work in the same way, with the obvious difference being the varying factors and elements of risk involved. Inflation-linked gilts are an option sometimes sought out by bond investors. These follow the official inflation rates, and are of course victim to the possible ups and downs that come via doing so.

Cash bonds give the investor the opportunity to invest a sum of money which is then locked away for a set period of time, for the duration of which interest is earned. The longer the commitment to have the money locked away for, the higher the rate of interest rate, making them a reasonable choice for those with money they do not need ready and regular access to.

Emerging market bonds are issued by governments or companies based in the developing nations of the world, and are seen as higher risk due to the sometimes volatile and disruptive economies involved.

In recent times, the notion of ‘mini-bonds’ has gained some traction, as smaller companies look to circumnavigate business loans or banks and appeal directly to customers and other interested parties for money. Various perks and incentives are often offered, which include discounts and free products. While appealing to many, others view them as risky propositions due to the possibility of receiving less interest than promised, or even losing the entire investment.

In a similar manner, retail bonds were launched by The London Stock Exchange (LSE) in 2010, with a view to encouraging companies to go to personal investors directly with bonds that have low minimum investment.

Choosing how to buy bonds

There are several ways in which to invest and obtain bonds. Bond funds are possible, which offer many different investments, and can help to lower the risk by having a combination of more reliable bonds alongside more risky corporate ones. There are usually available via a fund manager, who can explain all the risks involved and assist with any questions, and charges a fee. The advantages of a bond fund manager are that they will be able to take advantage of any changes in the marketplace, and buy and sell bonds based on their current par. The alternative to this involves buying bonds from a company of your choosing, without the involvement of others, and without taking part in practices aimed at spreading the possible risks. The advantage is that you know you will get your money back as long as the company stays solvent. 

Calculating yields

Working out what the yield may be should form a part of any decision when looking at investing in bonds. Essentially used to refer to the amount of return an investor may receive on a bond, if it has been purchased at par, the yield will be equal to the coupon. If the bond has been purchased below par, then the yield will be higher than the original coupon. Likewise, if the bond has been purchased above par, it will be lower. To calculate the current yield, take interest, and divide it by the price paid for the bond.

Also important is the yield to maturity, sometimes known as the redemption yield; the annual return you would earn should you hold the bond for the entire period it is active. This includes all interest payments, as well as any elements of profit or loss that will be made when receiving the initial investment back.

A running yield will ignore the profit or loss made on investment return, and simply gives the bond yield for the year.

Looking at these elements is key to ensuring that investments that are bought and sold are done so as profitably as possible. While some will choose to buy a bond and keep it to maturity, it is more common to buy and sell bonds based on the marketplace. Paying attention to the various aspects of yields is an important part of this.

Assessing risk

Being aware of the many variables is a massive help in assessing the risks when investing bonds, and paying attention to the market is always recommended. Alongside this, however, there are other things that can be done to look at the issue.

Rating agencies look at bonds and give them a rating depending on how trustworthy they are, and how much risk they represent. While this is useful information, it is important not to rely entirely on these ratings, but instead use them as sort of indication, perhaps in conjunction with other information. Credit analysists perform similar roles, and can conduct their own assessments and reports on bonds. 

Provided for informational purposes only. Not designed as advice. Speak to your IFA or tax advisor for advice tailored to your individual circumstances.