The basics of bonds – MoneyWeek Investment Tutorials

Bonds are essentially loans that you make to a government or a company. In return for your capital, the issuer promises to pay you a fixed rate of interest over a set period and to return your initial investment, known as the principal, when the bond matures. This makes them a cornerstone of fixed-income investing, offering a predictable return stream compared to the variable performance of equities.

When you buy a bond, you are becoming a creditor to the issuer. This is a fundamentally different relationship from buying a share, which makes you a part-owner. The bond market is vast and liquid, providing a critical mechanism for governments to fund public projects and for corporations to finance expansion and operations. In practice, bondholders stand ahead of shareholders in the capital structure, meaning they have a higher claim on assets if the issuer faces financial distress.

The price of an existing bond on the secondary market fluctuates inversely with interest rates. If prevailing rates rise after you buy, the fixed interest payment of your bond becomes less attractive, so its market price typically falls. Conversely, if rates fall, the fixed payment is more valuable, and the bond’s price usually rises. This inverse relationship is one of the most fundamental concepts to grasp, as it directly drives the mark-to-market value of any bond position held outside of a hold-to-maturity strategy.

Understanding a few key metrics is essential for any bond investor:

• Coupon: The fixed annual interest rate paid on the bond’s face value.
• Yield: The effective rate of return, which factors in the bond’s current market price.
• Maturity Date: The specific future date when the principal amount will be repaid.
• Credit Rating: An assessment of the issuer’s ability to repay its debt, provided by agencies like Standard & Poor’s or Moody’s.

When evaluating a bond, a common pitfall is confusing the coupon rate with the yield. The coupon is static, but the yield changes as the market price moves. A bond bought at a premium will have a yield lower than its coupon, while a bond bought at a discount will have a yield higher than its coupon. Always base your expected return on the yield to maturity, not the coupon rate, when comparing bonds with different prices and maturities.

Government bonds, such as UK Gilts or US Treasuries, are generally considered lower-risk investments because they are backed by the taxing power of the state. Corporate bonds typically offer higher yields to compensate investors for the greater risk of the company defaulting on its payments. For a detailed overview of UK government debt, you can refer to the Debt Management Office website.

Including bonds in a portfolio can provide diversification and reduce overall volatility. Their regular income and relative stability can balance out the higher growth potential, and risk, associated with stocks.