Bonds sound safe, warm and cuddly: "My word is my bond" and so on. But they aren't. Bonds are complicated.
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A bond is an instrument that pays a predetermined rate of interest over a fixed period of time (the "term") before returning your original investment. Sometimes the term is infinite, when the bond is said to be "irredeemable".
Bonds are loans in tradeable form. They are created by organisations that want to raise money. The bond is a promise by the organisation to the holder to pay regular interest and a capital sum at some future date. In exchange for this promise the holder gives the organisation money. The organisation is said to 'issue' the bonds and is the 'issuer'. The issuee, who is the first holder, is said to 'buy' the bonds. The bonds can then be bought and sold for prices determined as in any market - by buyers'/sellers' perception of the value of the promise the bond represents.
Sounds pretty simple, eh? But it gets complicated because of two things:
- the mathematics of interest rates, and
- the risk of default
Types of bond
There are any number of ways to categorise bonds. We think the most useful split is into:
- Government Bonds (UK government bonds are called "gilt-edged" or "gilts")
- Corporate Bonds (bonds issued by companies) of investment grade
- Other Corporate bonds (sometimes called "junk bonds" or "high yield bonds")
There are many other innovative bond variants, such as convertible bonds and bonds with attached warrants, which are perfectly respectable but for the experienced investor only.
In all bonds the things that matter are the yield, the term and the default risk.
"Yield" is more complex than it seems. You need to understand:
- the different types of yield - running yield, yield to maturity, yield to redemption and coupon. See Yield.
- the effect of interest rate changes on capital values. See Yield.
- the term structure of interest rates (a 5-year bond will have a different yield to redemption to a 10-year bond). See Yield Curve.
To evaluate a bond the market needs to judge the default risk. This is the risk that capital will not be returned on time, or ever. Bonds with a higher default risk need to have a higher yield in compensation.
There is no default risk on gilts. There is a tiny, but non-zero, default risk on the bonds of other developed economies. If you want to judge the default risk on the bonds of Upper Ruritania, the best of luck.
The analysis of default risk on a corporate bond is a complex technical task. It's possibly harder than judging the price of an equity share. Junks bonds will have a higher default risk than investment grade bonds.
You may have skipped over the points in 'Yield' above. We emphasise: if long-term interest rates move from 4% to 5% the price of a long-term bond will drop 20%. This applies just as much to your safe-as-houses gilt as to your dodgy junk bond. Yield.
Beware of instruments described as bonds that turn out not to be the sort of bond you thought they were. For example, Structured Bonds.
It is difficult to buy bonds. The unskilled private investor gets driven towards bond funds. And that is not necessarily a good place to be.