Investing in bonds, pooling your money with thousands of other small investors

Bonds are debt issued by either a government or a company and are an essential building block of many investors’ portfolios. When you buy a bond, you are effectively extending a loan to the issuer of the bond.

 

The issuer agrees to pay you a set interest rate (the ‘coupon’) at a set number of times per year before returning your initial ‘loan’ in its entirety at the date set out at the issuance of the bond (the ‘maturity date’). If the company (or country) defaults, you’re not going to get that loan back.

Spread your risk
Most private investors in the UK do not buy individual bonds direct, but invest through bond funds. By investing in a bond fund, you are effectively pooling your money with thousands of other small investors. That money will be invested in a portfolio of perhaps 50 or 100 different bonds, enabling you to spread your risk. Even if one bond defaults and investors get nothing back whatsoever, the impact on the fund is relatively minor.

Having said that, the opportunities for UK investors to buy individual bonds are increasing following the introduction of the Order Book for Retail Bonds (ORB) by the London Stock Exchange. It’s also worth noting that both individual bonds and bond funds can be included in a Stocks & Shares ISA.

Real value of money
People invest in bonds for a steady income and do not usually expect growth on their investment. Their capital tends to be fairly safe, although some bonds are safer than others. The less safe a bond is perceived to be, the higher the coupon: it has to compensate investors for the risk they are taking.

One of the risks of investing in bonds is that inflation will erode the real value of your money. This is the same risk you face if you leave your money in cash. As a result, the lower inflation falls, the more popular bonds tend to be with investors. If inflation turns negative (deflation), it can be a dream scenario for bond investors. They buy a bond for £1, and when they get their £1 back on maturity, it is worth more than it was before.

Denominated in currencies
A further risk of investing in bonds denominated in currencies other than sterling is currency risk. If you buy a Japanese bond and the value of the yen falls against the pound, you’ll be sitting on a loss in sterling terms.

Bonds fall into two main types: government bonds and corporate bonds. Government bonds have colourful names depending on which government issued them. UK government bonds are gilts, US government bonds are treasuries and German bonds are bunds.

Regarded as safe
A government bond is seen as quite low risk, as it is unlikely that governments will go bankrupt. Admittedly, recent events in the Eurozone have made investors much more nervous about the bonds issued by certain debt-burdened countries. But bonds issued by the UK and US are still regarded as safe and hence have low coupons. After all, governments can always print more money to meet repayments (although this would probably lead to inflation, reducing the value of the bond in real terms).

The level of risk associated to a corporate bond depends entirely on the company issuing the bond. The greater the probability of a company not being able to meet its repayments, the higher the coupon. Ratings agencies rate both government and corporate bonds for the benefit of investors; however, they can be wrong, as witnessed during the financial crisis of 2008.

Bond funds
• Gilt funds, which invest in UK government bonds

• Traditional corporate bond funds, which invest mainly in bonds that are issued by companies in the UK. They may also put a minority of their assets into gilts

• Global bond funds, which buy bonds from high-quality companies around the world

• High-yield funds, which invest in lower quality companies but will normally pay out more due to the higher risk

• Emerging market bond funds, which invest in the government debt of developing countries such as Brazil.

• (Emerging market corporate bond funds are very rare because companies in emerging markets are seen as too risky)

• Strategic bond funds, which have a wide remit and can buy anything from risky high-yield bonds to gilts. These may be more or less risky depending on the fund manager’s strategy

• Bonds are still seen as lower risk than equities – a relative safe haven against global economic problems. Of course, this depends on which equities and which bonds; a high-yield bond may be riskier than a defensive blue-chip equity