Investing In Bonds

What is a Bond?

Bonds allow governments and companies to borrow money from investors for a fixed period of time. The issuer of the bond will agree to pay a certain level of interest periodically (the coupon) as well as returning the full capital value at a given date in the future (the maturity date).

What are the risks of investing in a Bond?

There are 3 main risks when investing in bonds:

  • Credit risk – this is the risk that the issuer of the bond will not pay the interest that is owed to the bond holder or the full capital at the date of maturity. If an issuer fails to make an interest or capital payment, they will be in default.
  • Interest rate risk – as the level of interest paid by a particular bond is fixed, if interest rates rise the price that someone would be willing to pay for that bond will fall in order to compensate them for the lower level of interest they will receive compared to the prevailing market interest rate. Longer dated bonds are generally more sensitive to this risk than shorter dated bonds as the lower interest rate paid by the bond is locked in for longer and so a higher level of compensation is required.
  • Liquidity risk - this is the risk that a given bond may not have enough willing buyers or sellers to allow you to trade the bond at an acceptable price on in a sufficient volume.

Why do you invest in Bonds?

Bonds can provide a steady stream of income for the portfolio. Certain types of bond such as high investment grade and government bonds can also be very low risk investments helping to provide some level of certainty in returns. It is important to be aware that as a rule the lowest risk bonds generally provide the lowest level of returns. Low risk bonds can help to protect the capital value of portfolios in times of equity market stress helping to reduce the volatility in portfolio returns. Generally, the proportion of bonds held in a portfolio will decrease as you move up the risk scale.

How are Bonds taxed?

In general, the coupons on bonds will be taxed to income and there will be no capital gains tax to pay on any rise in the capital value of a bond between it purchase and sale. However, there are some instances in which capital gains tax will apply. If you require further clarification on the tax treatment of bonds you should consult your tax advisor.