Bonds are one of the most common investments available to savers but can be daunting to people that are unsure of what they mean.
Shares, which we covered in our most recent article (LINK), are easier to understand. You buy a small part of a company and hope that the price rises.
With bonds, it is different, but although scary to begin with, they are far less complicated once you know how they actually work.
As such in this part of Trustnet’s first time investor series, we’ll be exploring bonds so that investing doesn’t seem quite so intimidating to new comers.
A bond is essentially a loan you make to a company or government – when an organisation wants to borrow money (known as the issuer), you can lend to them via a bond.
You can decide when they have to pay you back and in the meantime the issuer will pay you interest on that loan.
This is a payment that the issuer makes to you throughout the duration of the bond’s lifetime as a reward for lending to them.
The interest paid to you is worked out as a percentage of the amount you lent to the issuer, known as the yield.
Say you bought a five-year bond for £100 and it had a yield of 5% that is paid to you annually – over those five years, you’d have received £5 a year, making you a total of £25.
When the bond expires, the issuer would pay you back the initial £100 investment and you’d have made an extra £25 profit on interest payments.
Due to this fixed rate of payment, bonds are typically considered a more reliable investment than shares. The price of shares can change a lot depending on movements in the market, whereas bonds have a fixed plan of payments.
Investors can potentially make much more money by investing in shares, but many people don’t mind taking home a smaller return for more reliability and safety in bonds.
However, like anything, there are risks involved and one way to know if a bond is riskier is to look at its yield. If a company has a high likelihood of not paying you back (known as defaulting), its bonds will often have a higher yield because you are taking more risk by investing in them.
The risk of default varies depending on the issuer, of which there are typically two main options available: government or corporate.
Lending to a government may also be called a sovereign bond. In the UK it could also be called a gilt, while other countries may have other names for their bonds, all meaning broadly the same thing. Alternatively you can lend to a business, which is known as a corporate bond.
Sovereign bonds are typically considered the sturdiest of the two because governments are well established institutions with large treasuries.
Corporate bonds, on the other hand, can be riskier because businesses face financial troubles. If a company you have bought a bond with goes under, you will not get your loan back from them. This is, despite being rare, also the case if a government were to default.
Duration, or the amount of time there is left on the bond before its maturity (it ends), is also a factor in the yield.
Short-term bonds often have a lower yield because the near future is easier to predict and gives the issuer less time to default, meaning it is less likely. If you buy a one-year bond therefore, it might pay you less because the issuer’s situation is unlikely to change.
However, a 10-year bond may have a higher yield because a lot more can change within a decade that would alter a company of government’s ability to repay investors.
There is a lot more to bonds, which we will cover in more detail in later articles, but this gives the basic overview. Next we will look at government bonds in more detail, including the different types available and how you can own them.