A Beginners Guide to Investing in Bonds

A beginners guide to investing in bonds

A beginners guide to investing in bonds

This is a beginners guide to investing in bonds. Essentially bonds are straightforward: the buyer of the bond lends money to a company or government for a fixed period of time, providing that company or government doesn’t go bust – they are paid a fixed or variable rate of interest and receive their capital back at the end.

But there are a lot of variables. An example being that it is possible to change the length of that loan. If the term changes from, say, five years to 10 years, there is far more time for the company to go bankrupt or default, for interest rates to change and for inflation to rise.

How much interest should bond holders receive? Do they pay enough to make it worthwhile moving out of cash? Do their interest payments rise with inflation? Before you know it, the world of bonds starts to look very complicated indeed.

BONDS: THE RISKS

There are a number of key considerations when assessing a bond. Notably time, the interest rate, the issuer and the economic environment. Like that of any other asset, the price of every bond will reflect the likelihood of being paid back.

If there is a greater chance of an investor not getting their money back – a longer time frame or a riskier issuer, for example – they should demand a higher return in order to take the risk. This is standard practice in the bond market, but does not strictly say you will not get your money back. Like any form of investment – payday loans for example. The customer cannot source a loan from a typical high street lender, so the payday loan company steps in. They charge a higher rate of interest to that customer for the risk they potentially pose in not repaying the borrowed funds. Well it’s the same in this instance, except you are the payday lender and the bond issuer the customer.

Elements in the economic environment – higher inflation, stronger growth – will also influence the price investors demand to lend money.

Looking at these these factors in turn: time is a vital part of any bond. Each bond has a given time until maturity, but the most important measure is ‘duration’, a slightly different calculation.

BOND DURATION

The longer a bond is termed, the more riskier it is, because you wait longer to get your cash back. Typical bond issuance’s are between 3-5 years although you can see shorter and far longer, depending on the institution behind the bond.

The duration will typically be shorter than the maturity date because investors will have got some of their money back from the interest payments. This is important because it measures the sensitivity of individual bonds to changes in interest rates.

Adrian Hull, fixed income product specialist at Kames, says: ‘Normally, investors would expect to receive a higher income for investing for longer, though at the moment you don’t get much more for investing for 30 years than for 10 years.’

The bond issuer is also important (government or corporation issuing the bond). Investors can demand more to lend to less trustworthy borrowers where there is more chance they won’t get their money back at the end of the term. There are two main types of bond issuer – governments and corporate.

The price of a government bond is largely influenced by expectations of interest rates and inflation. Note that ‘expectations’ are not the same as reality. Recently, the yield on the 10-year UK government bond (GILT) has moved from 0.5 per cent in mid-August 2016, to 1.5 per cent by mid-December.

Interest rates have remained at 0.25 per cent throughout that period, but – crucially – expectations of inflation have changed, largely thanks to the prospect of higher government spending.

HOW TO CALCULATE A BOND YIELD

There are a number of methods to calculate a bond’s yield. ‘Yield to maturity’ gives the annual return if the bond is held to maturity or full term and all interest payments are reinvested at the current yield. It also factors in any capital gain or loss at redemption.

‘Running yield’ takes no account of the capital loss or gain on redemption. It simply gives the bond yield each year, similar to a dividend payment. Investors may also hear the term ‘nominal yield’ – effectively the same as the bond coupon.

WHAT DOES IT MEAN FOR BOND YIELDS?

One key thing to remember is that a rise in the price of a bond means a fall in the yield and vice versa.

Inflation

Bonds usually pay a fixed income, which won’t rise with inflation. That means the income becomes less valuable if inflation rises. When bond prices fall, yields rise.

Deflation

Bonds’ fixed coupons become much more valuable in a time of falling prices.

Higher interest rates

If investors can get, say, 5 per cent on their savings (remember those days?), they have less incentive to invest in a bond. Coupons need to be higher to encourage people to lend.

Quantitative easing

QE has the effect of creating more demand for certain types of bonds. The central bank is a price-insensitive buyer of higher-quality corporate and government bonds. This pushes up demand, so prices remain high and yields low.

Recession

A recession is usually accompanied by falling interest rates and potential deflation. This is a good environment for bonds. Yields fall and prices rise.