|Bonds sound safe, warm and cuddly:
"My word is my bond" and so on. But they aren't. Bonds
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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).
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.
Beware of instruments described as bonds that turn out not to be
the sort of bond you thought they were. For example, Structured
It is difficult to buy bonds. The unskilled private
investor gets driven towards bond
funds. And that is not a good place to be.