All you need to know about bonds

published 25 March 2016

Bonds are very simple things. They are just IOUs issued by a government to raise money to cover spending that isn't already covered by tax revenues; or issued by a company to raise money to finance various business activities. They represent a promise to pay the investor a set level of interest (the "coupon") during the lifetime of the bond, and to repay the money in full on a set date.

In the UK, government bonds are called gilts (short for gilt-edged securities), and in America they're known as Treasuries (because they are issued by the US Treasury). So a debt certificate worth £100, with a coupon of 2.5%, set to mature in 2020, would mean that the bondholder has lent the government £100 (bonds are usually issued in £100 units), which he will get back when the bond "matures" in 2020. In the meantime, he will get £2.50 2.5% of the bond's face value per year.

The bond market is huge (it dwarfs the stockmarket) and government debt was publicly traded for years before equities really got a look in: in the late 18th century, for example, no one dabbled in the stockmarket they just had a few thousand pounds in the "four percents" instead (government debt that paid 4% a year). Elizabeth Bennett in Jane Austen's Pride and Prejudice has £1,000 worth. Mr Darcy has rather more.

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What moves bond prices

If general rates rise then the rate offered by your bond will start to look relatively less attractive, and the bond price will fall as a result. If rates fall, your bond's offering will look more attractive, so the price of the bond will rise.

Imagine a government or firm sells ten-year 3% bonds at £100 each. This means you get £3 a year for every year you hold the bond: a yield of 3%. That may seem fair when rates in general are around 3%. But what if general rates rise to around 5%, with savings rates from high-street banks therefore paying more than bonds? Who would want a bond paying just 3% then? No one. So the market price of the bond will fall until it is paying a yield of nearer 5%.

Bond prices will also reflect what the market thinks will happen to interest rates in the future. If rates are expected to rise, investors will sell to lock in any capital gains and prices will fall. If rates are expected to fall, bond investors will buy now to lock in higher yields and capture future capital gains, so prices will rise. Therefore, anything that affects interest rates inflation, economic growth, and expectations about both also affects bond prices.

The key thing to remember is this. When interest rates go up, bond prices go down. When rates go down, bond prices go up.

Not risk-free at all

If inflation rises fast and interest rates do the same, then the value of any bonds you hold could plummet. Inflation will also erode the "real" value of your original capital: £100 might not be worth the same when you get it back as when you invested it.

It is also possible to lose a great deal of money on bonds bought from companies: corporate bonds are affected by interest rates as much as government bonds, but while one assumes that the government will pay back its debts, the same is not true of the corporate sector: if there is any suggestion that a firm may not be able to pay back its debts, the value of any bonds it has issued will fall.

If you buy bonds in a company or for that matter a government that actually defaults on its debt, you could lose all your money. So bonds are not a risk-free investment.

The great bond bubble

There is much talk about interest rates going even lower they are already negative in much of the world. And if they do, then government (or "sovereign") bond prices at least will, of course, go higher. However, given that inflation isn't dead and that negative interest rates are a very controversial policy, that isn't a risk we want to take!

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast - but still writes for Moneyweek monthly.

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.