How to invest in bonds

Bonds usually appeal to investors seeking an income stream and a certain level of capital protection. Traditionally viewed as ‘safer’ than equities while offering better returns than a cash account, bonds typically form part of a diversified, long-term portfolio. How big a part will depend on your attitude to risk and personal views on the asset class.

If you want to buy bonds, you may find the easiest way to do so is through a bond fund. Your money gets combined with lots of other people’s so it can be spread across a range of bonds. What’s more, you get professionals thoroughly researching the investments for you, which is good, because bonds can be pretty complicated.

Understanding the basics

Governments and companies issue bonds as a way of borrowing money. When you buy a bond, you are effectively lending money. Just like that government or company would pay interest on a loan if they borrowed from a bank, they instead give you a regular interest payment. After a period of time, they should also pay back your original amount.

There are three bond terms you should know:

• Principal: the original cost of the bond (i.e. the amount you lend the government or company).
• Coupon: the rate of the regular interest payment you receive. It is a fixed amount, expressed as a percentage, that is set when the bond is issued. It is also sometimes referred to as ‘income’ or ‘yield’.
• Maturity: the date when the loan expires and the principal is repaid.

What’s so complicated about that?

So far so good, right? Things get more interesting. Once a bond has been issued, the original buyer does not have to keep it. They may sell it on a ‘secondary market’, where it can then be traded just like a company’s shares.

This means that bond prices can go up and down and you might not end up getting back the original amount you invest. And although the coupon rate is set when the bond is issued, the level of income you actually receive may vary. This is where the skill of a bond fund manager comes into play, as the good ones will analyse a range of factors to determine the outlook for each and every bond in which they invest.

The four main influences on bond prices are:

• Interest rates: normally, bond prices tend to move in the opposite direction to interest rates. To illustrate this, imagine you are choosing between a savings account that pays 0.25% interest and a bond that offers interest of 1.25%. You may well pick the bond. But, over a year or so, imagine the Bank of England raises interest rates and the banks follow suit. Now, a savings account might pay you 2%. Suddenly, the 1.25% rate that was fixed when the bond was issued doesn’t look so appealing and so its price is likely to fall.
• Inflation: because the income paid by bonds is usually fixed at the time they are issued, high or rising inflation can be a problem, as it erodes the real return you receive. For example, although a bond paying interest of 5% might sound great on its own, if inflation is 4.5%, your ‘real return’ is only 0.5%. On the other hand, if inflation is falling, the bond may be even more appealing.
• Issuer outlook: in addition to these macroeconomic factors, bond buyers also have to consider the outlook of the company or government issuing the bond. If its fortunes worsen or improve, this can also impact a bond’s price – particularly if it looks like the issuer may struggle to pay back its lenders when the bond reaches maturity.
• Supply and demand: if a lot of companies or governments suddenly need to borrow, there will be many bonds from investors to choose from, so prices are likely to fall. Equally, if more investors want to buy bonds than there are on offer, prices are likely to rise.

What are the different types of bonds?

Bonds are normally graded according to their issuers’ ability to repay their debt – i.e. their credit worthiness. Ratings agencies such as Standard & Poor’s and Moody’s use letters ranging from AAA (the highest quality) to CCC or D (the lowest quality), to provide this information to investors.

A company or government with a high credit rating is considered to be ‘investment grade’. Because the risk of losing money on these types of bonds is lower, you’re probably likely to get less interest too. These bonds will typically include those issued by developed market governments and big, stable corporations.

The bonds issued by a company or government with a low credit rating are referred to as ‘high yield’ or ‘junk’ bonds. Because the issuer has a higher risk of failing to repay their loan, you should receive a higher rate of interest as a trade-off for taking that risk. These bonds will usually include those issued by emerging market governments and potentially by smaller firms or firms whose credit rating has been downgraded due to a poor profit outlook.

Finding the Elite Funds

We’ve Elite Rated a range of bond funds to help you to invest. These are sometimes also referred to in the industry as ‘fixed interest’ or ‘fixed income’ funds.

We rate only a handful of funds, which we believe to be the ‘best of breed’, across the Investment Association’s bond sectors:

• Strategic bonds: this is the most flexible type of bond fund. It can invest in any type of bond – government, investment grade, high yield and emerging market – as well as other fixed interest investments.
• Corporate bonds: funds in this sector invest only in bonds issued by companies, although these could be investment grade or high yield.
• High yield bonds: these funds will typically offer a higher rate of income than those in strategic or corporate sectors, as they will invest almost wholly in high yield, higher risk bonds.
• Emerging market bonds: these funds invest in bonds issued by governments and companies that are based in emerging markets. As with all emerging market investments, they are typically higher risk than those bond funds that concentrate on developed markets.