Understanding bond investments

Posted on: 15th September 2022 in Investments

What are bonds, and how are they used by investors to make money?

In this article, we look at bond investments and how they can be used to form part of a broader investment strategy.

What are bonds?

The concept of borrowing isn’t something new for most of us. We usually borrow to fund a big purchase, such as taking out a mortgage to buy a home.

But what about when a large company or even a country needs to borrow money? This is where bonds come in.

Bonds, otherwise known as fixed-income products, are debt instruments issued to raise money and fund projects. Think of them as an IOU. When an investor buys a bond, they are essentially lending a business or government money.

How bonds work

As we mentioned above, when you buy a bond, you are lending the issuer money.

In return, the issuer agrees to pay back the principal amount of the bond at maturity. The bond issuer also pays interest over a set period of time. These are called coupon payments.

Unlike buying stocks and shares in a company, bonds do not give individual investor ownership rights.

There are three key terms to be aware of when investing in bonds:

• Issuer – this is the entity that issues the bond to borrow money.
• Issue price – the original price of the bond set by the issuer. Bonds are typically issued at par. The term ‘par’ simply means face value.
• Coupon – the rate of interest the issuer commits to pay on the face value of the bond. Payments are typically either annual or biannual.
• Maturity – this is the date the issuer will pay back the bond’s face value to the bondholder.

Investors do not need to hold onto a bond until it reaches maturity.

For example, if you were to invest in a 10-year government bond, you are not locked into that investment for 10 years. The bond itself can be bought and sold on a secondary market.

Selling bonds on the secondary market for more than the purchase price and through interest payments are two ways investors can make money from bonds.

What are the different types of bonds?

There is a range of bonds available to investors. However, in general, there are three main types of bonds.

Government bonds

As the name implies, these types of bonds are issued by governments to support spending. UK government bonds are called gilts, while in the U.S., they are called treasuries.

These are the most common products found on the bond market. While interest rates may be generally lower, government bonds often have lower default risk. In other words, a country is less likely to default on a loan than a company.

Corporate bonds

Bond markets tend to offer lower interest rates and more favourable terms than borrowing from a bank. So, companies looking to expand or raise capital for other initiatives can secure a loan by issuing bonds.

Corporate bonds have a higher risk of default than government bonds. However, investors usually benefit from higher interest rates because the potential risk is higher.

Municipal bonds

While government bonds are issued by the national government, these bonds are issued by towns, cities and local authorities.

Municipal bonds are typically used to fund public services or projects. Unlike corporate bonds, coupon payments from some municipal bonds are tax-free.

Are bond investments a good choice?

Like any investment, bond investments have their pros and cons. Some of the pros include:

Steady income stream

Bonds can provide a steady income stream through regular interest payments. Payments are usually predictable as they pay a fixed amount twice a year. Not only that, you receive your principal amount back at the time of maturity.

Lower risk

Stocks and shares investments are often volatile and carry a higher level of risk. Meanwhile, bonds, especially central government bonds, are much lower risk options. While prices do fluctuate, they do so far less than equities.

Diversification

One of the biggest draws of bonds is that they help investors build a diversified portfolio. Bonds and higher-risk asset classes such as equities have an inverse relationship. Because of this, bonds can be used to offset the overall risk of an investment portfolio.

Of course, like any investment, bonds carry a level of risk, and there are no guarantees. Some of the cons include:

Liquidity risk

While bonds can be sold on the financial markets, there is the risk that you may not find a buyer, leaving you unable to sell.

Economic downturns

Long-term bonds are susceptible to economic changes, and the market price of a bond can change over time. Factors such as inflation risk, inflation rates and the issuer’s credit rating can all have an impact on bond prices.

An extended period of economic downturn can take its toll on a business.

If a company is struggling financially, it could end up defaulting. This may result in you not getting your original investment amount back. You may also lose out on interest payments.

Lower returns

Bonds historically have much lower returns than other investments, such as stocks and shares. Between 1928 and 2010, the average return for stocks was 11.3%. Meanwhile, bonds only averaged 5.28%.

So, holding only a portfolio of bonds may not generate the returns needed to reach your investment goals.

The bottom line

There are financial risks that come with any type of investment. While bond investments are typically on the lower end of the risk scale, they are not risk-free.

One of the main draws for investors is how they can help to lower the overall portfolio risk as part of their investment strategy.

Mixing them with other assets such as investment funds, equities or property investments can help spread the risk and build a diverse portfolio.

With so many options available to investors, knowing the best option for you can be challenging. That’s where we can help.

Holborn Assets is a leading, award-winning financial services company.

For over 20 years, we have successfully worked with clients to build and manage their investment portfolios. Our investment strategies are tailored to the client’s needs, goals and tolerance for financial risk.

Start your investment journey with us. Contact us using the form below and find out how we can help you.