Bonds have traditionally been viewed as being lower risk than equities. Generally, bonds generate stable flows of income, providing greater certainty of nominal cash flow. Bonds can act as a hedge against periods of economic uncertainty, or unanticipated periods of deflation. On the downside, bonds have lower historical and expected returns than some other asset classes, notably equities.
When you buy a bond, you are lending money to a government, or a company. The bond has a fixed rate of interest and usually a date at which the loan will be repaid. The coupon is the nominal rate of interest paid by the bond when it is issued.
The advantages of bonds are that you receive a pre-determined level of income and you know when and how much you will receive when the borrower repays you. This can be regarded as a low risk investment, as long as you are confident the borrower will be able to meet their commitments to paying interest and repaying your loan. Furthermore, the price of bonds changes over time, so you only know exactly how much your bond is worth if you hold it to redemption.
Bond prices are determined by demand and supply. Two main factors affect the demand for bonds generally. These are interest rates and the rate of inflation.
Interest rates are important, because higher bank rates will attract investors to move from bonds to cash. The coupon is fixed and the capital value of the bond must change to reflect the level of other interest rates. Higher interest rates increase the return on cash and variable bonds, making the fixed yield on bonds less attractive (by comparison) and pushing the price down (and therefore increasing the yield to competitive levels).
Inflation impacts on bonds, because the market will adjust to allow for its effect on income. Fear of rising inflation means bond prices will fall and yields rise and the reverse will happen when inflation looks set to fall or stay low.
The yield curve tells you how much income you receive from bonds. A 'normal' yield curve slopes upwards from left to right, reflecting the fact investors should be rewarded for holding longer dated bonds by receiving a higher income or yield.
When you invest in gilts you make a loan to the UK government. In return, the government undertakes to pay the money back at a specified future date and to pay a fixed rate of interest on the loan until then. Since it is fixed, the flow of income from the gilt cannot rise over time in the same way as equity dividends. The capital value of the gilt on maturity also does not change.
Corporate bonds are a way for companies to borrow money from investors. They are structured in the same way as government gilts, as they pay coupons and return the face value to the bondholder at maturity. Where they generally differ most significantly from government bonds is in the level of risk.
You need to consider the risk of corporate bonds defaulting, which means they cannot pay back the money they have borrowed and make interest payments.
Corporate bonds usually offer a higher yield than government bonds, because the credit risk is deemed to be higher, which means it is believed they are more likely to default on payments. Those companies regarded as the largest and most financially stable, however, are able to issue bonds at lower yields than those in emerging markets with volatile politics and economic instability.
Provided there is no default, you should receive a higher return from a corporate bond than government bonds, in return for the potentially higher risk. Credit rating agencies give ratings to bond issuers. A rating is reviewed at least once a year and more often if the company makes an announcement such as a profits warning. The rating provides an opinion on the likelihood of the issuer being able to repay the money you lend. Nevertheless, this is only an opinion and not a definitive guide. Equally, ratings agencies were shown by US congressional and regulatory investigations to have conflicts of interest in the aftermath of the financial crisis of 2008, where they allowed commercial considerations to influence the ratings they issued to mortgage bonds, so their ratings may not always be accurate.
Corporate bonds are divided into investment grade and high yield bonds. These reflect the risk profile and potential return that you should expect from bonds, with investment grade being the lower risk and offering a lower yield. Those bonds that are high yield may have been former investment grade bonds that have fallen out of favour. Or they may have been issued as higher risk bonds, because of the perceived relatively weak financial strength of the company concerned. They tend to have the characteristics of bond investments, but with underlying risk and return characteristics more akin to equity investments. While returns from top quality investment grade bonds are more closely correlated to government bond returns, high yield returns can differ significantly.
Index-linked gilts are defensive investments, designed to preserve the real value of your capital and income. The annual income and capital value on the repayment are linked to the rate of retail price inflation. Over the life of index-linked gilts, they offer you the certainty of preserving the value of your capital/income against rising retail price inflation. They only provide this protection, however, if they are held until maturity. During their life, the price of index-linked gilts is determined by demand and supply. Therefore, the price may fall in the short term. It is important to remember, however, that the measure of the rate of retail price inflation is an average. Each person is impacted by different rates of inflation depending on the goods and services they buy. Thus the extent to which they protect you against inflation is dependent on the goods and services you purchase.
Emerging markets offer both government and corporate fixed interest, which are also divided into investment grade and high yield. Emerging market bonds are available in dollar denominated paper and local currency. These bonds are regarded as higher risk than those issued in developed markets, but spreads have narrowed in recent years. The differential in yields between emerging market bonds and US government bonds, known as spreads, reflects the perceived risk of the former.
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