A Quick, Easy Guide to Investing in Fixed Interest Securities (“Bonds”)
As Independent Financial Advisers (IFAs) in Lincoln, we have seen hundreds of client portfolios in our time. For the vast majority of them, bonds have been an important part of their investment mix.
In this article, we’re going to outline what bonds are, how they work and also answer some common questions about them which we receive from people across Lincolnshire.
What are bonds?
A bond can be thought of as an “IOU” – a request for capital, typically from an “issuer” such as a company or government. You can then buy this bond, effectively agreeing to lend money to the issuer in exchange for repayment with interest.
How do they work?
Bonds are rated by bond rating agencies, with AAA ratings being the very best. In general, the higher the bond rating the less interest you will earn on it, since there is less perceived risk.
When you invest in a bond, you agree to a promised schedule of interest payments (sometimes called “coupon payments”). You also agree to a date when the loan will be fully repaid, which is known as the maturity date.
Why do people own bonds?
Bonds provide a trade off when it comes to investing. On the one hand, our Independent Financial Advisers in Lincoln would generally agree that, in general, bonds provide unexciting returns. Often these are below inflation.
Yet conversely, they are an important way to protect an investment portfolio from traumatic falls in equity and real estate markets.
Consider the Credit Crisis, for instance, between November 2007 and February 2009. An investment portfolio comprising 100% UK equity would have fallen much more than a portfolio comprising 40% bonds and 60% UK equity, for instance.
What types of bonds are there?
Broadly speaking, governments and companies can issue bonds.
The former types is also known as “government bonds”. Bonds issued by the British Government are called “gilts”, and are denominated in British pounds. In the US, government bonds are called U.S. Treasury securities.
Gilts can generally be split into two types. Index-linked gilts are linked to inflation, and nominal gilts which are not. The latter comprise the majority of UK government debt.
Bonds issued by companies are often called corporate bonds. These are typically seen as higher-risk than government bonds, since companies are typically seen as more likely than governments to default on their debts. As a result, the interest yield tends to be higher.
Bonds pay a predetermined schedule of interest payments, thought the price of them can vary during their term as they can be traded prior to the end of their term (maturity).
How do I invest in bonds?
As mentioned, there are different types of bonds. From there, there are lots of ways you can then invest in them.
You can buy investment bonds directly through a stock broker, alternatively, you can invest through a financial adviser. Using collectives or funds of bonds can help spread the risk associated in lending to just one company and form part of a diversified portfolio,
In general, if you are not confident or knowledgeable in these areas it’s always best to speak with an independent financial adviser first. Most – such as our IFAs in Lincoln – will offer you an initial consultation at their cost to help clarify your thinking and get your started.
What considerations should I make prior to investing in bonds?
Broadly speaking, before you invest in bonds you need to consider the wider economic environment, interest rates, the issuer, the bond price and the time until redemption (when the bond comes to the end of its term and (hopefully!) returns your investment capital borrowed).
For instance, take the latter – “time”. The further away the maturity date of the loan is, the more risk there is that the loan will not be repaid.
As a result, a higher return should be demanded. The same logic applies if the bond issuer is less reliable than other issuers in the market.
Looking more closely at the first consideration (the wider economic environment), it’s a wise idea to pay particular attention to where we are in the economic cycle and inflation. The higher the latter the more likely central banks are to raise interest rates. This typically is not good for bonds, since it increases the returns you get from cash as it means the fixed interest rate payable by bonds are less attractive and consequently, generally, depresses their prices in the market.
Higher inflation reduces the value of the bond interest repayments you receive and should be factored into your portfolio planning.
How much of my portfolio should consist of bonds?
This is a crucially important question, and one that is best answered in discussion with a financial adviser who understands your financial needs, goals and circumstances.
Broadly speaking, most people will have bonds in their investment portfolio to a greater or lesser extent. Some big determinants of the precise mix include your age, the length of time you aim to invest, your investment experience and your personal tolerance to risk.
The percentage of bonds in your portfolio often describes the overall level of risk that portfolio is exposed to. For instance, a very “defensive” or “conservative” portfolio might have more bonds than shares, whilst a more “aggressive” or “risk-taking” portfolio would have more shares than bonds and such bonds are likely be higher yielding (riskier) and exposure to overseas bonds.
Ultimately, the precise balance will depend very much on your individual situation and objectives. Working with an independent financial adviser will help you work through the complex issues to land on an ideal portfolio balance, specifically for you.
Over time, they can also help you rebalance your portfolio to keep it on track and in line with your investment goals and preferred portfolio risk profile.
Should I invest in bonds, or bond funds?
It is possible to invest in individual bonds, certainly if your investment capital is substantial. For those with a smaller amount to invest, a bond fund (or “bond mutual fund”) offers an alternative.
A bond fund pools your money with that of other investors in order to purchase a set of bonds. Here are some advantages to investing in bond funds:
- Allowing less-wealthy people to achieve a lot more investment diversification.
- Typically higher interest rates than bank accounts and money market funds.
On the other hand, here are some drawbacks to be aware of prior to investing in bond funds:
- Your income from the bond fund fluctuates, because the bond assets contained in the fund are constantly changing.