Bonds have been a popular choice among income-seeking investors in the past, but low and negative yields have put many off the asset class. How do bonds work and what part do they play in your investment portfolio?
What is a Bond?
Companies and governments raise money by issuing bonds and they attract investors looking for income and some degree of capital security. Governments use the money for public spending on health, education and defence, for example, and firms issue bonds to fund projects and acquisitions.They could be seen as "IOUs" on a grand scale - you lend your money and, at the end of an agreed period, you should get it back in full.
Bonds are seen as less risky than equities and have historically held up well in the face of stock market volatility. UK government bonds, or gilts, for example, are seen as “risk-free” in that the chances of the UK defaulting are minimal. While bonds are seen as poor relations in investment terms to equities over the very long term in terms of returns, there are some environments in which they are the best performing asset class. That because, the price of a bond rises and falls in line with supply and demand too, so there can be capital gains to be had. In the last 20 years, despite a very prolonged bull run for shares, bonds have also performed well - as yields have fallen over the years, bond prices have gone up.
Understanding Bonds
Retail investors often prefer shares over bonds because they are perceived as easier to understand. Certainly there are more variables to take into account when investing in bonds – for example if you hold them to maturity the returns are different than if you sell before the bond matures. Inflation, interest rates, economic growth and ratings agencies all have an impact on bonds. Expected changes in interest rates also have an impact on the bond market - UK gilt yields have risen in the autumn of 2021 in anticipation of the Bank of England raising rates from record lows.
But there are some very straightforward aspects to bonds – when their prices rise, their yields fall and vice versa. Higher demand for bonds pushes up their prices and, as a result, yields fall (this is similar to equities, where a dividend yield falls as a share price rises). Unpopular bonds, such as Greek government debt during the 2012 crisis, had very high yields to reflect the risk investors were taking that the government would default.
Bonds are often referred to as “fixed-income securities” because the pay a fixed coupon. If a UK Government bond has a “maturity” of 2031, paying a yield of 0.90% at the end of November 2021, that means that you will receive 0.90% on your investment for 10 years, usually paid twice a year. If you hold until maturity your will receive your original capital back. An equity investor, in contrast, is subject to the fortunes of a business: one year shares may pay a dividend yield of 5%, but the company could scrap its dividend the following year.
Bond investors often trade off that security for a lower but more predictable yield if they need to meet particular liabilities. This often suits pension funds, for example, which know they must pay out fixed sums to pensioners at set dates.
Long-term government bonds help pension funds make payments because they know they will get a predictable income stream and they will get their money back at the end of the holding period.
An investment in a share is far less predictable – the company could be like Amazon – whose share price has multiplied in 10 years – or more like Wirecard, whose shares slumped as it went into insolvency amid accusations of fraud. Pension funds investing in blowout companies see their capital destroyed and will have lost income payments in the process.
What often puts investors off is the complexity of bond pricing and how that determines how much money you make. Bonds often trade above or below “par value”. If you buy a bond above its nominal value and hold that to maturity, you are guaranteed to make a capital loss – for example a £100 bond might be trading at £150 three years before maturity, but if you hold it to maturity you will still only get £100 back. In reality, bonds are traded between issue and maturity and capital values go up and down.
How to Buy Bonds
While direct investing in bonds is less popular than equities in the UK, it’s still possible to buy government and corporate bonds.
Corporate bonds for large companies like Tesco are easily tradeable through stockbrokers and can be held in Isas and Sipps. Government bonds can also be bought through mainstream platforms, but whether you'd want to is debatable: most gilts pay negative yields and because of the demand, you are guaranteed a capital loss if you hold them to maturity.
One perk of holding corporate bonds is that they rank higher than ordinary shares if a company goes bust – bondholders should receive some (though not all) of their money back.
Most UK investors prefer bond funds to direct investing, not least because the complexities of the bond market tends to favour professional investors. But bond funds are also less risky than owning a bond directly yourself because they spread their risk against many different bonds, often of different maturities and issued by different entitities.
There are plenty of active and passive options for investors. Costs are coming down every year, although bond index funds are generally more expensive than stock market trackers.
The fall in yields across the developed world in recent yields, to in some cases negative interest rates, means that investors have had to look further afield and take more risk for income. Emerging market bond funds, both active and passive, have grown in popularity.
This article has been updated for our November 2021 special report week.
