Bonds...a term that many people have heard about, but few people know about.
On the surface, bonds are relatively straight forward. Companies often need money to finance certain activities or projects; to do this they look to obtain a loan. One of the ways they can obtain a loan, is through a bond. A bond is a debt instrument which individuals can invest in and receive interest in return. It's a very straight forward financial instrument, however, the multiple varieties mean that it's often deemed quite a confusing instrument.
Bonds can either be corporate or government bonds.
How Does It Work?
A company, or the government issues a bond with a set interest rate (yield), and end date (maturity date).
A bond's yield is dependent on the following factors:
- the issuer of the bond
- economic conditions
- maturity date of the bond
Fundamentally, the riskier the bond, the higher the yield on the bond.
In the UK, government bonds are called Gilts; the UK government has never failed to pay interest, or pay back the loan amount in full, making it one of the safest investments you can invest in.
In the US, government bonds are called Treasury Securities, and in Japan they are know as JGBs (Japanese Government Bonds). Most countries issue bonds to the market; obviously the more politically unstable the country, the higher the yield you should expect to get paid. You are taking the risk that the bond will be defaulted upon, or that interest payments will be delayed; for example Argentina, which has defaulted 8 times on government bonds, had the largest default to date in 2014 (there has subsequently been higher defaults).
The other bond issuer are corporates, trying to raise funds. Credit institutions value bonds in the market, and give them a rating. This rating helps set the yield rate on the bond. The better the rating, the lower the yield, but the higher chances of you being paid back.
The maturity date is the date that, I the investor, will be paid back my money. The longer out the maturity date (i.e the furthest in the future), the more chance the corporate has of going bankrupt, and therefore the higher the yield on the bond.
Economic conditions really impact the yield on a bond, particularly, interest rates and inflation...
When interest rates are higher, bonds need to have higher yields so people invest their cash in bonds over cash investments. When inflation is high, this is invariably bad for bonds as the value of repayments further down the line is less.
Wait? What did I just say?! Inflation means that money today is worth less tomorrow as your buying power of money decreases (remember the earlier blogs where I discussed that increasing inflation meant goods were more expensive). So interest payments in 15 years time are worth less than they are today. With that in mind, bonds with shorter maturity dates, might provide better returns.
How Do I Invest In Bonds?
Until recently, you could only invest in bonds if you had a minimum of £100,000, which most people don't have. There are a couple of other ways to access the bond market. The first is through brokers, and the second is through a company called WiseAlpha, which allows you to invest in specific bonds. Check them out here.
Lets Not Forget The Tax...
Tax on bonds is a little odd;
- Interest received on bonds is taxed as income.
- When you sell the bond, however, the capital gains you make is not taxable; this only applies to UK government bonds, and UK corporate bonds. The bond also has to be a "qualifying corporate bond"; the definition of this and categories associated with it are found on HMRCs website.
- Your bond, however, can fall within the ISA allowances, if it meets the following criteria:
- The bond must have a minimum term of 5 years and be listed on a recognised stock exchange
- There is an annual ISA limit; the bond income must fall within this limit, and
Bonds are a fantastic way to investment. I personally hold a diversified asset portfolio covering stocks and shares, property, pension and bonds.
Photo from the beautiful unsplash.com