What is a bond, and what are the risks?
Bonds are tradable debt instruments that allow governments and companies to borrow money from investors for a defined 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).
In the case of government bonds, the payment of interest and repayment of capital are backed by the issuing government – for example, UK government bonds (often called gilts) are backed by the UK government.
In the case of bonds issued by companies, interest and capital payments are backed by the relevant company. The company must make all of its bond payments before being allowed to pay any dividends to shareholders, and as such are safer investments than holding shares in the equity of the same company.
What are the risks of investing in a bond?
There are three 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 others would be willing to pay for that bond will fall to compensate them for the lower level of interest they will receive compared to the prevailing market interest rates. 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 or in a sufficient volume.
Investing in bonds on behalf of investors
Bonds can provide a steady stream of income for our portfolios. Certain types of bond such as high quality company and government bonds represent lower risk investments, helping to provide some level of certainty in returns if they are held to maturity. It is important to be aware that as a rule the lowest risk bonds generally provide the lowest level of returns.
Low risk bonds often 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.
Choosing which bonds to invest in
When investing in bonds we will first consider the way to make the investment. Most of the time, we find that using an ETF or mutual fund to gain a diversified exposure is most appropriate, for example, with corporate and overseas bonds using a collective investment vehicle can offer significant efficiency of cost and market access.
Alternatively, in the rare cases when we invest in a single bond issue we will consider the credit quality of the issuer, the time until the bond matures and the level of yield the bond is paying (this is the amount of return we expect to make from buying the bond and holding it to its maturity).
Do investors pay charges to invest in bonds?
We do not charge any transaction fees for buying bonds. Where we invest in bonds via collective investment vehicles such as ETFs and mutual funds, there will be fees as explained in the ETFs and Mutual Funds sections of our Knowledge Centre.
Please note, the value of your investments can go down as well as up.