by Bill Blevins, Financial Correspondent

When people think of investing, the first option that comes to mind is the stockmarket.  It is the form of investment that is discussed the most, including daily media commentary.  There is another form of investment, however, which although fairly common and rewarding does not generate the same sort of interest as equities.  I’m talking about bonds.  News desks do not devote much time to bonds and they can be considered “boring”; after all, you rarely hear of anyone earning a fortune from bonds, and in a raging bull market they may seem to offer insignificant returns compared to equities.

I prefer to use the word “reliable” rather than “boring”, however, and it only takes a bear market to remind investors of the virtues of bond investment’s safety and stability.   Over the last few years, many investors have been thankful for this form of investment.

Bond basics 

Bonds are part of the asset class known as fixed-income securities.  They are debt obligations, meaning one party borrows money from another, who expects to be paid back the original capital plus interest.   Investors (the holders of the bond) can expect to earn money through the interest earned and the changing price of the bond (bonds fluctuate in price just like any security).

Both governments and corporations need to borrow money occasionally, and often do so by issuing bonds.  Thousands of investors then lend a portion of the capital needed.  In other words, a bond is a loan where you are the lender.

The government or corporation that sells the bond is known as the issuer.  The interest rate is sometimes referred to as the “coupon”.  The date on which the issuer has to repay the amount borrowed (known as the “face value”) is called the “maturity date”.  Bonds are fixed-income securities because you know the amount of capital you will get back, provided you hold the bond until maturity.

The difference between stockmarket and bond investment is that bonds are debt whereas stocks are equity.   When you purchase individual stocks you become a part owner in a corporation and receive voting rights and a share in future profits.  When you purchase a bond you become a creditor to the corporation or government.  One significant advantage is that creditors have a higher claim on assets than shareholders.  In the case of bankruptcy, bondholders get paid before shareholders.   On the other hand, bond holders do not share in the profits if the company does well – they remain entitled to the capital plus interest.

In general, therefore, there is less risk in owning bonds compared to owning equities, but this may come at the cost of lower potential returns.    Over the longer term, the best returns tend to come from equity investment; however this does not mean that you should not invest in bonds.   Bonds are a more appropriate investment in certain cases, such as when you cannot tolerate the short-term volatility of the stockmarket.   They also are a useful investment choice in retirement as your capital will be relatively safe and you can live off the fixed interest they provide.

It is always wise to have a diversified portfolio in any case, one which includes more than one type of investment asset.  Bonds and equities compliment each other in a diversified portfolio and owning both can help stabilise returns.  The weightings of each asset class can be adjusted according to your changing needs. 

Bond characteristics 

There are a number of characteristics of a bond that you need to be aware of.  

The face value (also known as the par value or principal) is the amount of money a holder will receive back once the bond matures.   However, the par value is not the price of the bond.  The price fluctuates throughout the bond’s life in response to a number of variables.  When a bond’s price trades above face value it is said to be selling at a premium; when it sells below face value it is selling at a discount.

Bonds pay interest rates regularly - every six months, or monthly, quarterly or annually.  The interest rate is expressed as a percentage of the par value.  A rate that stays as a fixed percentage of the par value is known as a fixed-rate bond; a floating-rate bond is one with an adjustable interest payment.

Maturity dates can vary from one day to 30 years or even longer. A short term bond is more predicable and therefore less risky than a long-term one.  To compensate, longer-term bonds will pay higher interest rates.

The interest rates also vary according to the issuer.  The less stable the issuer, the higher the risk, and in return you will earn a higher rate of interest.  Government bonds (“gilts” in the UK and “treasuries” in the US) are considered very low risk and therefore pay the lowest interest.  Corporations are graded according to their credit worthiness by agencies like Moody’s and Standard and Poor’s.   Companies graded BBB, A, AA & AAA (by S&P) are called “investment grade”.   Those lower are speculative grade, usually called “high yield bonds” because they pay the highest rates of interest. (They can also be called “junk bonds”.)

If you hold a bond to maturity you will receive the capital back, however you can also sell it any time in the open market.  In this case the price and the yield will affect how much money you will earn. This is where it can get complicated, as when the price goes up the yield goes down, and vice versa, yet both can be good things, depending on your position.

Bond funds 

This is best left to the experts, and the simplest method of bond investment is to own a bond fund.   In this case an experienced bond manager will buy and sell bonds within the fund in order to earn the most money for the fund holders.  He will select the right amounts of investment and non-investment grade bonds to balance earning potential with stability, and will keep a close – and experienced – eye on the market to determine when to buy and when to sell each bond in the fund.

A bond fund also offers you much greater diversity than just owning a few individual bonds, as many different sectors, geographical regions, currencies and credit ratings will be included in the bond.  Also, if you do not need the interest payments you can reinvest them in the bond, allowing for increased growth. 

In actual fact, bonds are not “boring” at all and should be included in most portfolios.  A bond fund can also provide an alternative to leaving your capital on deposit, one not affected by inflation or currency risk.  If you place your bond fund within an insurance product, it is also likely that you will pay less tax.  Now that’s got to be exciting!

© Bill Blevins
Blevins Franks International Limited

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