How do bonds work? And should you invest in them?

What’s a bull run?

In a bull run, people are confident and buying shares left, right and centre as values rise across the board. An optimistic trader will be called ‘bullish’. A bull run is the opposite of a bear run. But we’re not giving any prizes for guessing what the mood has to be to make somebody ‘bearish’ in their outlook.

Word is bond

A bond is, at its most simple, an IOU from either a government or corporation. An entity will sell bonds in order to fund activities, such as investment. So, when somebody buys a bond, they are buying debt. This article will focus on UK government bonds.

UK government bonds are known as ‘gilts’ (and US government bonds known as ‘treasuries’).  They come in all sorts of flavours, but we’ll concentrate on the standard gilt set-up, known as ‘conventional gilts’; they make up 75% of those available and are the easiest to understand.

A conventional gilt is a promise by the UK government to pay its holder a fixed cash sum every six months until the gilt reaches its maturity date. This can vary from three years from the issue date to 30 years. Upon maturity, you’ll get the original face value back. 

Gilts have a face value, usually £100, but this isn't always what the gilt costs to buy. You may have paid more than the face value in order to get the regular interest payments. As with most things financial, there is a highly active secondary market, and buying a 30-year gilt doesn’t necessarily mean you’ll keep it for 30 years either. You might sell it for more or less than its face value.

Hundreds of billions of pounds’ worth of bonds are traded back and forth every day, and depending on how the market values them, their price fluctuates as much as the price for an ordinary share does.

Here’s how a conventional bond could be described:

Face value: £100
Coupon: 5%
Redemption date: 2025
Price: £100

  • The face value is how much the UK government will pay the bondholder once the bond matures.
  • The coupon is how much of the face value the UK government will pay the bondholder every six months.
  • The redemption date is when the bond will mature.
  • The price is how much the market believes the bond is worth at the current moment in time. In this example, the price is the same as the face value. This is called ‘trading at par’.
  • The yield - how much you get - is 5% per year. Easy.

 

But - and this is where bonds can get a little complicated - imagine you wanted to buy a bond and you saw this:

Face value: £100
Coupon: 5%
Redemption date: 2025
Price: £93

  • We calculate the yield by doing the following: 100/93 * 5 = 5.38%.
  • And if the price is higher - £109, for example? 100/109 * 5 = 4.59%.

 

The relationship is clear: when bond prices fall, yields rise, and when prices rise, yields fall. The Bank of England’s (BoE) policy since the financial crisis of 2008 has been to buy lots (and lots and lots) of bonds with the aim of putting fresh money into the banking system. The result has been a lowering of yields as prices go up due to demand from the BoE.

This has been exacerbated by the worldwide hunt for income. With low interest rates in our current low-growth environment, investors have been buying bonds at a huge rate because they can’t find anywhere else to put their money with the accompanying lack of risk, therefore driving up prices to even higher levels.

Why do people bother with bonds?

The obvious reason for people purchasing gilts, and as mentioned above, is that they are very low risk. Redemption is guaranteed by the Treasury, and if the Treasury did run out of money it can always print more, as we’ve seen recently with quantitative easing. Not an ideal situation overall, but the UK government not honouring its debts would have implications on a scale that is quite difficult to imagine.

Argentina provides an example, though. The country defaulted on its bonds in 2001 to the tune of $132 billion. This was at the tail end of the 1998 - 2002 ‘Argentine great depression’. 10 years after this, despite massive debt restructuring programs in the interim, which saw the majority of bonds bought back by the government, Argentina’s borrowing costs were almost double the average for other developing countries (their default cost them their credit rating). It only returned to the bond market in April of 2016 - and to roaring success, selling $16.5 billion worth. As a minor point of interest, it’s worth noting that these bonds were rated as ‘junk,’ meaning that rating agencies believed the risk of default was significant. To combat this, the government offered high coupons.

Going back to gilts, which are issued by a far more stable government and economy (although the hysterical press would like to convince us all otherwise), their low-risk rating means that the big pension funds buy a lot of them, and in fact many of these funds must hold a certain percentage of their portfolio as government bonds as part of the fund requirements.

We know that gilts are relatively safe. They can also be a bet against an interest rate rise. Take our 5% example. If you bought a £10,000 bond at par, you’ll be getting 5% per year. Compare that to a standard UK savings account right now. Even if you sock it away for 5 years you’ll be lucky to hit 2%.

So in this case, bonds earn you a lot more money than saving your cash does. But, if strong rumours of an interest rate do start to do the rounds, long-dated bonds suddenly look a lot less attractive, as they lock you into payments that could well be below those offered via a higher rate. Prices will fall as demand dries up. However, new bonds will be issued at the new interest rate.

There is also a relationship with inflation. Inflation has been extremely low for the last few years, but Brexit will mostly likely lead to higher inflation, as reported in the 2016 Autumn Statement. If inflation rises, the buying power of £1 decreases. Therefore, the money you receive from a bond is worth less than what it was.

For this reason, rising inflation makes existing bonds less attractive, and prices fall as, again, demand is lacking.

 

Bonds and government spending

When a government is running a deficit - i.e. when it’s spending more than it’s bringing in (as ours is currently), or it needs to raise cash for big project spending, it needs to borrow money and so it sells bonds. It also needs to continue paying the coupon on existing bonds. A higher coupon makes a bond more attractive to a buyer, and so if the government is desperate, it needs to issue bonds that are expensive to pay off - and so borrowing costs for the government rise.

Why political events affect bond prices

Currently, the world is uncertain about what shape Brexit will take, how Donald Trump will communicate and deal with Asia and Europe and South America. Additionally, there is the not-insignificant uncertainty over political trends in Europe next year. If the UK does have to do a ‘hard Brexit’ and tax revenues drop as a result of the accompanying loss of confidence from consumers and businesses, the UK’s credit rating may fall. This means that newly issued bonds would need higher coupons in order to attract investors - higher borrowing costs for Philip Hammond.

Globally we are seeing rising mistrust of government and its ruling classes. Add to this the prospect of rising inflation and the feeling that central banks will simply have to raise interest rates soon (especially in the US), plus Donald Trump's rhetoric about a $1 trillion investment initiative, which would require a lot of borrowing, and you end up with traders keen to sell their bonds, which they feel will soon look like a rather limp asset class.

How to invest in bonds

If you’re investing for income or want to lower the risk of your equity portfolio, rather than just investing in shares you should have a portion of your portfolio in bond funds. There are lots of different types of bond funds, each giving exposure to different types of bonds.

If you want diversified exposure to fixed income, start with a fund from the Investment Association’s Strategic Bond sector. These funds are able to invest in a wide variety of government, investment-grade corporate and high yield bonds.

This makes them the ideal one-stop shop for anyone who feels more comfortable letting professional fund managers decide which parts of the market have the best chance of delivering decent returns. One to consider is the Jupiter Strategic Bond Fund. This is go-anywhere bond fund that aims for a high income and capital growth by seeking out the best fixed- income opportunities in the world.

We also like the Kames Absolute Return Bond Fund which aims to generate positive absolute returns for investors over a rolling three-year period, irrespective of market conditions.

Both these funds are members of Moneywise’s First 50 Funds for beginners, which includes other bond fund options, including funds that track major bond indices.

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