What are bonds and how do they work?

Bonds are one of the main types of asset you can invest in. Investing in bonds is normally considered as lower risk than investing in the stock market but, as is often the case, there can be pitfalls for the unwary.

Here we look at what bonds are, how bonds work, their various different types, and the pros and cons of investing in bonds.

What is a bond?

A bond is essentially just a loan to another party, usually to a large organisation like a company or a government.

The loan is usually for a fixed period of time after which the initial amount (known as the principal) has to be repaid. Bonds normally last anywhere from a few years to a few decades. The length of time until a bond has to be repaid is called its duration, so short duration bonds are set to be repaid within a few years and long duration typically refers to a few decades.

The rate of interest charged is usually fixed and therefore doesn’t change over the course of the loan. There are exceptions though – for example, some bonds have their interest charges linked to any changes in the rate of inflation.

The fixed length of time they last for and the (mostly) fixed rate of interest they pay out is why bonds are sometimes referred to as fixed-income investments.

Bonds are normally tradeable as well, meaning that you can sell them to someone else. In fact, most bonds will have many different owners over their lifetime.

Investing in bonds is big business. Very big in fact. It’s reckoned that global bonds markets are worth more than global stock markets.

How do bonds work?

Bonds are fairly simple financial instruments, in theory at least. When a company, organisation, or government decides it needs to raise money, it will have various options and one of these is to issue a bond.

Financial documents will be drawn up, covering things like the amount to be raised, the length of the bond, the rate of interest charged, how frequently interest will be paid, and what recourse investors have should any interest payments not be paid.

The initial offer of a bond will usually just be made to large investors. But after that process is complete then the bonds may begin trading on a market. There will be a quoted price at which you can either buy or sell the bond and this will change throughout each trading day.

It tends to be bonds for larger companies and governments that trade on a public market as they are the only ones where there is sufficient demand on a regular basis.

Each year, the bond will pay interest to whomever owns it at the time. At the end of its life, known as its maturity date, the amount of the bond should be repaid in full.

What are bonds called?

One useful feature of bonds is that their names tend to be fairly descriptive and they follow a fairly set format.

For example, let’s use TESCO PLC 1.982% INDX LKD NTS 24/03/36 as an example. It looks confusing but let’s break it down.

The name of the bond issuer comes first – in this case, the supermarket chain Tesco – followed by the annual rate of interest which is 1.982%. 

INDX LKD is shorthand for index linked, telling you the rate of interest is linked to the rate of inflation. NTS is short for notes, another name for a bond. 

Lastly, 24/03/36 tells you that this bond is due to be repaid on 24 March 2036.

What makes bond prices move?

If you are investing in bonds, you need to be aware of the two main things that can cause the price of a bond to move.

The first is what is happening to interest rates in general. The second is what investors think about the likelihood that the company or government will repay the interest and the final amount due.

Let’s take interest rates first. If interest rates are expected to rise, then both the fixed amount of interest a bond pays out and the final sum due become less valuable. Likewise, if interest rates are expected to fall, then the fixed amount of interest and final sum become more valuable and the price of the bond should rise.

Short-term bonds, due to be repaid in just a few years, tend to move less in price when interest rates change as the amounts paid to the bondholders aren’t far in the future.

Long-dated bonds, not due to be repaid for a few decades, are very sensitive to interest rate changes, as their payments are spread over a very long period and it doesn’t take much movement in rates to significantly affect the current value of all those future payments.

Changes in interest rate expectations affect all bonds, albeit to varying degrees. The second factor, the perceived ability of the company or government to repay what it owes on time, is a more specific risk to individual bonds.

If a company runs into financial trouble, then the price of its bonds will fall as it’s deemed more of a credit risk and it could default on its payments. Similarly, if its finances improve, the price of its bonds should rise. 

You’ll sometimes hear a bond being described as investment grade – this simply means the risk of whoever issued the bond not paying out is deemed to be extremely low.

There are credit rating agencies — the three main ones being Moody’s, S&P, and Fitch — who assign various grades to different bonds based on their view of the risk of any default. They all use slightly different terminology (such as Aa1, AA+, Baa1 etc) but those starting with A are typically the best, with very low expected default rates. Those starting with C tend to be highly speculative, with B sitting between these two extremes.

What are the different types of bonds?

There are two main types of bonds that UK investors need to be aware of.

Government bonds

Government bonds are normally the lowest risk of all bonds and therefore tend to have the lowest rates of interest as the risk of default is generally deemed to be very, very low.

UK government bonds are called gilts and US government bonds are known as treasuries. These, and European and Japanese government bonds, tend to be most popular and have the lowest rates of all.

Corporate bonds

A bond issued by a company is known as a corporate bond. The markets for these tend to be quite a lot smaller than for government bonds and the spread (the difference between the price at which you can buy and at which you can sell) tends to be quite a lot wider. 

There are a couple of other names you might come across. Junk bonds is a collective term for bonds that pay a high rate of interest because they have quite a high risk of default. Municipal bonds is a US term that covers bonds issued by local governmental bodies such as states or municipalities, usually to fund specific projects.

What is a bond fund?

A bond fund is simply a type of investment fund that holds lots of different types of bonds. As individual bonds can be quite expensive for ordinary investors to trade, bond funds tend to be the most common method of investing in bonds.

You can either buy a bond fund that invests in all different types of bonds, or you can buy one that specialises in either government or corporate bonds. There are even bond funds that will allow you to buy a collection of similar bonds, such as UK government bonds with less than 5 years left to maturity.

Can you make money from bonds?

You can certainly make money investing in bonds. In fact, as interest rates have generally been falling over the last few decades, investing in bonds has proved to be very profitable indeed.

Whether the same is true in future is a matter of much debate. Some people expect interest rates to move higher over the next few years and that would probably mean the returns from bonds will be much lower than they have been in the last few decades. However, there is no certainty that will happen and many people have been expecting the trend in interest rates to reverse for a long time already.

What we can say is that any move in interest rates is likely to affect the prices of long-dated bonds much more than short-dated ones. So, if you plan to invest in bonds, it makes sense to consider how well diversified you are across different lengths of bonds.

Advantages of investing in bonds

The main advantage of investing in bonds is that their prices tend to be more stable than other types of asset like shares or commodities. You know what payments you are going to get and when, which is useful if you are drawing your portfolio down to fund your living expenses in retirement. As a very general rule, the older you are, the more of your portfolio it makes sense to have in bonds.

It’s unusual for bonds as a whole to lose a significant amount over the course of a year, although individual bonds tend to be a lot more volatile.

You can also use bonds as a diversifier for a stock portfolio. Typically, when stock markets rise, bond markets will tend to fall and vice versa. So you can use this to rebalance your portfolio over the economic style, buying a few more stocks when they are cheaper and selling a few when they are cheaper. This can smooth out your overall returns over time.

You may come across people mentioning the 60:40 portfolio, which has long been considered the default portfolio for the typical investor, comprising 60% stocks and 40% in bonds and then rebalanced on a regular basis.

The stability of bond prices, and the income they pay out, also attracts investors who don’t like that much in the way of price volatility.

Disadvantages of investing in bonds

The returns from bonds tend to be lower than other assets over the long term, so if you plan to be invested for many decades, other types of investment may be more suitable.

The returns from bonds are also dependent on what happens to interest rates, so even if you pick what turn out to be the best bonds of any given type, their overall returns often end up being quite similar and largely out of your control.

Should you invest in bonds?

There is no clear answer to this question unfortunately as it will come down to your own unique personal circumstances.

Broadly speaking, the longer you have to invest, the larger your ability to deal with volatility, and the more you have to invest, all tend to reduce the amount of your portfolio it’s sensible to have invested in bonds.

And with interest rates at or near record lows, therefore seeming more likely to return to more normal levels, it’s more probable that the returns from bonds over the next few to several years could be lower than we have seen in the last couple of decades. Nobody knows if that will happen, though, or how long it might take if it does.