What should you expect if you invest in bonds?

In this, the third of our special two-page sections on the mechanics of investing, MoneyWeek looks at the benefits and drawbacks of bonds...

What are government bonds?

Government bonds are simply IOUs issued by a government to raise money to cover expenditure that isn't covered by their tax revenues. As such, they represent a promise to pay the holder a set level of interest (known as 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 the US, they're known as Treasuries (because they are issued by the US Treasury).

So a debt certificate worth £100, with a coupon of 4.5%, set to mature in 2015, would mean that the bondholder has lent the government £100 (bonds are usually issued in £100 units), which he will get back in full when the bond matures in 2015. In the meantime, he will get £4.5 or 4.5% of the face value of the bond every year. Government bonds are usually traded in different maturity categories: in the UK, they are referred to as shorts, which have less than seven years to run; mediums, which have seven to 15 years; and longs, which have more than 15 years to go. In May this year, the UK also launched 50-year gilts.

The bond market is huge (in the UK the gilt market alone is worth around £350bn) and government debt was publicly traded for years before equities really got a look in: back in the late 18th century, no one dabbled in the stockmarket - they just had a few thousand pounds in the 'four percents' (government debt that paid 4% a year Elizabeth Bennet in Jane Austen's Pride and Prejudice had £1,000 worth). In fact, it wasn't until the 1970s that big institutions started switching their investments out of bonds and into equities.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Do companies issue bonds?

Yes. They need to raise money too. However, it costs them more than it does the government. You can be pretty sure that the US and UK governments are going to pay you back, but you can't say the same for all companies. This means that they have to pay a higher coupon on their bonds than governments to compensate for these higher risk levels. Currently, the yield on ten-year Treasuries is around 4.23% calculated by dividing the coupon rate by the market price. However, if a company such as General Motors which was recently downgraded to junk status by rating agency Standard & Poor's wanted to raise money, it would have to offer a rate more in the region of 5.5%-6%.

How much do bonds cost?

If you buy a gilt direct from the government, it will cost you £100 which you will always get back at the end of the term. But between the start and end dates of the term, when bonds can be traded on the secondary market, the bond's value and hence its price will fluctuate. If interest rates rise, making the rate offered on the bond less attractive, the price of that bond will fall. If rates fall, the value of the bond will rise. Imagine a government or firm sells ten-year 5% bonds at £100 each. This means you get £5 a year for every year you hold the bond: a 'flat yield' of 5%. That may seem fair when base rates are around 5%. But what if general rates rise to around 7%, with savings rates offered by high-street banks therefore offering more than bonds? Who would want a bond paying just 5% then? No one. So the market price of the bond will fall until it is paying a yield of nearer 7% (to around £70).

This, however, doesn't take into account the fact that anyone who buys the bond on the secondary market at £70 will make capital gain of £30 at maturity, as well as receiving the coupon. Add this in and you get a total or 'redemption' yield (in this case slightly higher than the flat yield). However, the basic equation remains: rates up, bonds down; rates down, bonds up.

What else affects bonds?

Like the equity market, the price of government bonds will also reflect what the market thinks will happen to interest rates in the future. If interest rates are expected to rise, investors will sell to lock in any capital gains and prices will fall. If they are expected to fall, they will buy 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 bonds.

While corporate bonds are also affected by interest rates, the health of the firm that has issued the bonds is vital as well. Say profits plunge at a firm. Its share price will usually follow immediately as investors anticipate falling dividends, but the bonds may stay steady unless there is perceived to be a genuine risk that it may not be able to repay its debt. If there is, the bonds will fall too: the more sceptical investors are of a company's ability to repay its debt, the higher the yield they will demand as compensation for holding its bonds.

Who decides how risky a company's debt is?

Rating agencies assess the risk of a company defaulting on its debt and grade their bonds accordingly. The two main agencies are Moody's and Standard & Poor's (S&P). Both use a similar system to rate the safety or otherwise of a bond. Those least likely to see a default are rated AAA (for S&P) or Aaa (Moody's). Those in default are rated D. Only bonds rated BBB/Bbb or better are considered to be 'investment grade'. The rest are referred to as 'junk', or, more politely, 'high-yield' bonds. But the agencies aren't always right: Enron bonds were downgraded to junk from BBB+ only four days before the firm actually collapsed.

So I can make a capital loss in the bond market?

Yes. If you buy bonds in a company that actually defaults on its debt, you could make a 100% capital loss. Governments also occasionally default on debt; Argentina did in 2001. But you can also lose money in credit-worthy government bonds too. As an example, if you buy gilts that mature in five years, but the UK experiences an inflationary cycle that lasts some five years, investors who sell their gilts on the secondary market will lose out because their gilts will tumble in value. But even if you hang on until maturity, thanks to inflation, your £100 will have lost some of its purchasing power, and you, as the investor, will have made a capital loss.

So is now a bad time to be buying bonds?

That depends on what you believe will happen to interest rates in the UK. The price of oil is currently trading at record highs thus helping to push inflation up to an eight-year high of 2.3%, above the Bank of England's 2% target, suggesting that the Bank of England may have to lift interest rates. At the same time, however, the UK economy is weak: 2005 growth forecasts were recently cut from 2.5% to 2% and some think the economy may be in need of a rate cut. At MoneyWeek, we are concerned by rising inflationary risks and believe the Bank of England is unlikely to cut rates again. Instead, it may have to raise them to hold back rising prices. This would be bad news for the bond market. In the US, rates are also on the up. Federal Reserve chairman Alan Greenspan has said he intends to keep raising them at a 'measured pace'. Still, the US economy is not all that strong, so it is hard to know how long this pace will continue. Should the rate-hike cycle come to an end, bonds could start to look more attractive.

Emerging market bonds are considered to be more risky than those issued by developed countries. However, the difference between their yields and those on gilts and Treasuries (the 'yield spread') has been falling recently, suggesting that investors feel risk levels are falling (it is now its narrowest since the mid-1990s). Whether you invest in emerging market bonds or not depends on the extent to which you think this is true.

And corporate bonds?

Although a grade AAA corporate bond will move more or less in tandem with a gilt, as it is pretty much as low risk, more lowly rated bonds will react as much to market sentiment and the general interest-rate environment as to its own restructuring and cost-cutting. If the financial situation of the issuing company improves, and the risk of default is perceived to fall, the bond price may rise, regardless of wider rate movements. This means that bond investors can do well in times when the economy is considered to be improving by shifting into sub-investment grade bonds.

This is, however, far from a risk-free strategy the financial health of a firm can deteriorate as easily as it can improve.

Is there a safe way to invest in bonds?

Yes. Buy index-linked gilts - gilts which pay a coupon that varies according to the Consumer Price Index. Both the interest and capital payment on redemption are adjusted in line with inflation. In an inflationary environment, this is a great bonus, as the indexing maintains the purchasing power of your bonds. That makes them one of the safest investments available. Moreover, any gain arising from inflation indexing is not taxed. On the downside, yields on index-linked gilts tend to be much lower than on their conventional counterparts.

Where can I buy bonds?

Index-linked, or conventional gilts, can easily be bought through your stockbroker, the Bank of England's brokerage service, or directly via the Post Office or the Debt Management Office. Income from gilts is liable for tax, but capital gains are tax-free. It is possible to buy individual corporate bonds on the stockmarket; they generally trade in large lots, with the market dominated by professional traders.

Small investors may prefer to invest via a fund. The Schroder Monthly High Income fund is a low-risk fund that holds a diverse portfolio of debt securities and is a top performer in the Sterling Government Bond category. For higher-risk but higher-yielding bond funds, take a look at Invesco Perpetual Monthly Income Plus fund, which has posted 69.2% returns in the past three years and invests in high-yielding corporate and government bonds. The Threadneedle High Yield Bond fund returned 52.5% over the three years, and also looks to invest in higher-risk UK and international fixed-interest securities.