Whether you’re new to investing or looking to diversify your portfolio, understanding bonds is essential.
Bonds are debt securities that allow governments and corporations to borrow money from investors. In return, the issuer promises to pay back the borrowed amount, known as the principal, along with interest payments.
Not all bonds are created equal and, while most are deemed less risky than stocks, they still carry the risk that the government or company will default on the loan.
Benefits of bond investing
1. Income stream
Bonds, or fixed interest investments, often provide a predictable and steady income stream for investors through regular interest payments. These payments are typically made semi-annually or annually, offering investors a reliable source of income.
2. Portfolio diversification
Bonds are also a great source of diversification for an investment portfolio when combined with other asset classes like equities. Including bonds in a portfolio can help reduce risk by spreading investments across different types of assets. They can also provide stability during turbulent market conditions.
3. Multiple Risk Profiles
Fixed income investments also come in various types, each with different risk profiles. Investors can choose bonds based on their risk tolerance and investment goals to better align their money with their long term goals.
Different types of bonds
Bonds will typically fall into two categories: government or corporate bond.
1. Government Bonds
Government bonds are issued by national governments to finance their operations and projects. They are considered relatively low-risk investments. You may hear them referred to as ‘sovereign debt’, ‘Gilts’ (UK) or ‘US Treasuries’. Since these loans are backed by governments, those in developed markets are considered less risky while those in emerging markets carry a higher risk.
2. Corporate Bonds
As the name suggests, corporate bonds are issued by companies to raise capital for various purposes. Corporate bonds offer higher yields compared to government bonds but come with an additional level of risk.
3. Strategic Bonds
Strategic bond funds are the most flexible type of bond fund. They can invest in any type of bond – government, investment grade, high yield and emerging market, as well as other fixed interest investments.
It’s worth noting that due to their flexibility, no two funds in the IA Sterling Strategic Bond sector will be exactly the same. Some concentrate on generating income, while others are more concerned with capital preservation. It all depends on their stated aims and objectives.
Key factors to consider
1. Credit Ratings
Bonds are given a rating, or a grade, to indicate how likely they are to repay their debt. In investment speak this is called ‘credit quality’. The ratings are awarded by bond-rating agencies, not the issuer. These ratings use a letter system which ranges from AAA (the most likely to pay back the loan) to C (the least likely).
To simplify the jargon, we typically refer to bonds as being either investment grade or high yield.
- Investment grade bond
Investment grade means the bonds are considered higher quality and less risky by credit rating agencies, or rated AAA to BBB. Investment grade bonds are issued by financially stable companies with a lower risk of default. These bonds have higher credit ratings and are considered safer investments. They offer lower yields but are more reliable in terms of timely interest payments. - High yield bonds
High yield refers to those bonds rated BB or below, with the risk increasing as you move down the scale. You will typically see yields increase as the ratings decrease. High yield bonds are issued by companies with lower credit ratings or higher risk profiles. These bonds offer higher yields to compensate investors for the increased risk. While they can provide greater returns, they also come with a higher likelihood of default.
2. Interest Rates
Interest rates and bond prices have an inverse relationship. When interest rates rise, bond prices tend to fall, and vice versa. This is because existing bonds with lower interest rates become less attractive compared to newly issued bonds with higher rates.
Since payments on bonds are typically fixed, they remain the same throughout the bond’s life. When interest rates rise, newly issued bonds with higher coupon rates become available, offering investors higher income potential. This makes existing bonds with lower fixed coupon rates less attractive, potentially reducing their market value.
3. Maturity
The maturity of a bond refers to the length of time until the bond’s principal is repaid to the investor. Bonds can have short-term (typically up to 3 years) through to long-term (over 10 years) maturities. The maturity determines the duration of payments that an investor will receive with longer-maturity bonds providing a longer income stream.
Additionally, longer-maturity bonds generally offer higher yields compared to shorter-term bonds. This is because investors demand a higher yield as compensation for the longer time period they are tied up in the investment and the associated risks, such as interest rate fluctuations and inflation.
4. Duration
Duration is a measure of a bond’s sensitivity to changes in interest rates. It helps estimate the potential price change of a bond for a given change in interest rates. Duration is expressed in years and takes into account the bond’s payments, time to maturity, and the current level of interest rates.
Conclusion
Bonds, or fixed interest, is complex.
It’s important to note that while bonds offer several advantages, they also come with risks, such as interest rate risk and credit risk. It’s essential to carefully consider these risks and conduct thorough research before investing in bonds. Other factors such as credit risk, market conditions, and supply and demand dynamics can also impact bond prices and returns.
In summary, when considering bonds, it’s important to assess your risk tolerance, investment goals, and conduct thorough research. Bonds can be a valuable addition to a diversified portfolio.
