All you need to know about bonds

In the latest of our beginner’s guides to investing, Merryn Somerset Webb explains the basics of bonds.

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.

What moves bond prices

If you buy a bond when it is first issued, it will generally cost you £100, which you will always get back at the end of the term. But between the start and the end dates of the term you can sell the bond on, and then you may get more than £100 for it or you may get less, because bond prices react to changes in interest rates.

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

One important thing to bear in mind is that bonds are not necessarily a safe investment. If you go to a financial adviser, they will tell you that buying bonds is a low-risk purchase – but while this is often the case, it isn’t always.

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

Global interest rates have been trending down for going on 30 years. That means that bond prices have been trending up: every time most of us think they can go no higher, they just go higher. For some investors (including us) that makes the market look very, very dangerous.

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!