Investing in Bonds

This article is for information purposes only and does not form a recommendation to invest. The value of an investment may fall. Investing in precious metals, shares and bonds may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Bonds are IOUs issues by companies or governments when they need to raise cash. In the case of corporate bonds they are an alternative source of finances to shares/stocks, but instead of then owning part of the company and sharing the profits (which is fairly risky) with a bond you are promised your money back on a certain date with a regular fixed interest payment or "coupon" (originally called that because the bond certificate had coupons attached that could be torn off and redeamed on certain dates) Good solvent companies (or governments) will pay the coupons and the original sum.

Bonds can be traded after they have been issued and may have a value above or below the issue price so the coupon (yield) may be more or less than the original published yield and you may make a loss or gain if you hold to matturity. The Gross Redemption Yield is the effective percentage yield you will get if you do hang on to them until expiry (This value is available in financial publications and web-sites)

The value of the bond depends on how the apparent solvency, credit rating and bank interests rates have changes since issue (See below)

A simple rule of investing states that the higher the risk of an investment the higher the return. This is the Risk Premium: The amount you get paid for taking the extra risk. So if you want to make lots of money you need to take more risks. It is however possible to reduce the risk by building a balanced portfolio.

The risk of buying a single share or bond is high with many possible unknown influences on the price. Buying two bonds results in some reduction of risk because a drop in one price may not affect the other one adversely. Many shares/bonds are highly correlated to each other, so having two shares/bonds in the same field (e.g. BP and Shell) does not reduce the risk as much as two shares/bonds in unrelated industries (e.g. BP and Lloyds) Mixing shares with other asset-classes will also improve volatility of the over-all portfolio (e.g. mixing shares, bonds, property and gold bars)

Please see the separate balanced portfolio article...

Individual bonds can be purchased via a broker, in the same way you might buy shares, stocks etc. or you can buy bond-funds, mutual funds, unit trusts, investment trusts or Exchange Traded Funds - ETFs (or Zeros a more obscure bond-like alternative)

To diversify risk, as described above, you need exposure to a range of different bonds; if you want to buy many bonds in a relatively small portfolio you would incur a lot of charges from your broker. For instant exposure to bond markets ETFs (exchange Traded Funds) provide low cost exposure to whole markets or sub-sets of bond markets. For a managed, diversified exposure us mutual funds, unit trusts etc. which have higher charges (typically above 1% annual charge)

For more information about stock-brokers and trading shares/bonds, see this related article

Government bonds pay out a defined sum every year or half year (The "coupon") and a final sum on maturity on a predefined date. The income and final payment is predictable and governments of stable countries rarely default on their payments. Corporate bonds are similar and bond holders will always be paid first, before share-holders (but after any bank debt is paid), even if the company gets into financial trouble, but the health of a company's finances must always be taken into consideration.

Governments and corporate bonds are rated by rating agencies (Moody give ratings: Aaa to B3 and S&P and Fitch give AAA to CCC-) to indicate the chance of default. A bond rated at AAA or Aaa is extremely unlikely to default, AA/Aa1, A/A2, B/Ba2 or CCC/B3 are increasingly more likely to. Low rated bonds (rated Ba1 to B3 or BB+ to CCC-) are often called high-yield, Sub-investment grade or Junk bonds; the coupons are high to compensate for the chance of default. Higher rated bonds with low chance of default are called "investment grade bonds" (Aaa to Baa3 or AAA to BBB-)

Corporate bonds, in general, pay a higher yield depending on the perceived quality of the company. Alternatively Zero Dividend Preference Shares (See related article) provide the same function, but producing no income (zero dividend) producing their return entirely from capital gain - i.e. paying a predefined amount on a certain day in the future. These are ideal for financial planning and tax planning.

A simple rule of bond investment: When bank interest rates go down bond prices generally go up because the income from a bond is fixed so the income seems more attractive. How much the price goes up or down is determined by the "duration" of the bond. This is also a measure of risk of the bond; the longer the duration the riskier the bond.

Here's some maths, but ignore this if you prefer - the value of the Modified Duration is often published for each bond or fund, so knowing how it is calculated is not important

The duration concept was developed by F. Macaulay

Macaulay duration = SUM((PV(Cash Flow).t/P0)

where

(PV(Cash Flow) = the present value of cash flow to be received at time t

P0 = current price of the bond

Modified Duration = Mac_D/(1 + r)

where

r = yield to maturity

Investing in individual corporate bonds is fairly risky in that the company could default or go bust, so a portfolio of bonds would help to reduce the risk or better still a managed bond fund (e.g. an Exchange Traded Fund or ETF, mutual-fund, unit trust or OEIC) Unfortunately these do no have a defined end date, but they will have a average "duration" value published, just like any bond, which defines the weighted-average amount of time for the bond or fund's cash-flows to be received by the investor (i.e. how long before half of the total payout - coupons and redemption value - is received) Choosing an ETF with a similar duration to your ideal individual bond would give a similar effect. The lower the duration the less risky the bond or fund and the lower the sensitivity to the bank base rate - as bank base-rate goes up generally the bond-price goes down and vice versa:

Change in Bond-Price = -(Duration) x (Bond Price) x (Change in Bond Yield)

or more forally: dP = -(ModD)(P0)(dr)

Zero Dividend Preference Shares behave like a zero coupon bond which makes them far easier to use: no complicated duration calculations to worry about because all of the payout is at the end on the predefined end-date.

Related corporate bond article published on Helium.com