Alternative Investments

Posted:Abigail Andrews – Tuesday, June 26th, 2007

What are Bonds?

Generally, bonds are regarded as 'safer' than shares. This is true in a very general sense, since their prices tend to gyrate less dramatically than those of shares. However, different kinds of bonds offer different levels of safety. There are also circumstances where bonds can be very risky indeed. It is your choice how much risk you are willing to take.

If a borrower wants to borrow money one of the ways to do it is to issue Bonds. A Bond is basically an IOU (a loan) - a promise to pay back your original investment (your 'principal') at a later date, plus interest payments (the 'yield' or 'coupon') at regular intervals between now and then. Like all IOUs, how reliable it is depends on the borrower. There are broadly three types of borrowers:

Gilts: Governments of Leading Nations

These can be relied on to honour their obligations to bondholders. The UK government has never defaulted, i.e. failed to pay interest or principal, on its Bonds. These are known as Gilts, from the old days when gilt-edged certificates were issued. Your pension fund has to buy these to guarantee they will be able to pay you an annuity when you retire.

They are 'safe' so long as inflation remains low. However, when it is high, your interest payments will be worth less in real terms. Your principal will also lose much of its value. If you are worried about inflation, one way to protect yourself may be to buy index-linked gilts. Another is to stick to shares!

Corporate Bonds: Companies

These are always regarded as more risky than Gilts, because companies sometimes default. Obviously, the stronger they are financially, the less likely this is. Certain agencies give ratings to Bonds, so you can tell how risky the market thinks they are. AAA is the safest category. Anything in the B category or below would be too risky for the average investor.

Company Bonds tend to rise in value when business is picking up, and inflation and interest rates are falling, also since shares tend to do even better in these conditions, you will usually be better off in them. The main exception to this rule is when you are shifting the emphasis in your portfolio from growth to income. If so, you may consider diversifying by buying a Bond Fund rather than individual company bonds.

Governments of Developing Nations

These have proved to be very unreliable in the past. For example, Russia, Mexico and Brazil are all previous defaulters. Investing in this type of bond is strictly for veterans.

How Do Bonds Work?

The main feature that distinguishes a Bond from any other loan is that a Bond is tradeable. Investors can buy and sell Bonds without the need to refer to the original borrower. Over the entire life of the Bond the holder receives interest, which is known as the Coupon. The borrower also makes a promise to repay the loan (the Principal) on the maturity date.

How Risky are Bonds?

Bonds are often considered in times of economic and stock market uncertainty. Bonds (Gilts and other fixed interest securities) provide a generally secure income and capital return. They are marginally less volatile than equities and provide a more secure income return than cash. Bonds tend to complement well-diversified portfolios as another asset class next to equities.

Bonds are generally less risky than having a share in a company. One of the main risks is that the company you have lent money to can't pay the interest due or cannot pay the money back at the end of the term (for example, if it has gone bust).

It is generally considered that these risks do not apply to Gilts – a government is expected always to pay in full – though there have been instances of certain countries having been unable to repay. Bonds issued by governments will usually pay a lower rate of interest as a result of the perception that they are less risky.

Companies have different credit ratings and a company with a high credit rating is regarded as a safer bet than a company with a lower credit rating. Companies with a lower credit rating will have to offer a higher rate of interest on their Bonds than companies with the top credit rating, simply to attract investors and to compensate for the higher risk.

Bonds can be bought and sold in the market (like shares) and their price can vary from day to day. A rise or fall in the market price of a Bond does not affect what you would get back if you hold the Bond until it matures. You will only get back the nominal value of the bond in addition of course to any coupon payment to which you've been entitled during your ownership of the Bond, irrespective of what you paid for it. If you paid less than the nominal value then you will have made a capital gain when the Bond matures; and a capital loss if you paid more than the nominal value. This only applies if you buy a single Corporate Bond. It doesn't apply to Bond Funds (pooled investments). Because Bond funds invest in many different bonds there is no single maturity date for your investment.

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