What are bonds, how do they work and how do you buy them?

While rising interest rates have caused havoc in the mortgage market over the past year, there has been one silver lining: the reinstatement of appealing returns from cash and bonds.

And now that bonds are attractive once more – in the aftermath of the financial crisis they often paid effectively zero interest – investors may feel the need to understand them better.

Bonds are typically less well understood than shares so in this guide we will look at what exactly bonds are, the different types available, how they perform and the role they can play in your investment portfolio.

• What are bonds?
• What different types of bonds are there?
• Why hold bonds?
• What are the risks of investing in bonds?
• How to invest in bonds

What are bonds?

Bonds belong to a more general category of investments known as “fixed income” because they pay investors a fixed return over a fixed period of time (dividends from shares, by contrast, can rise and fall).

Within fixed income, bonds are the most common type of investment. Essentially, a bond is issued to an investor by a borrower in exchange for a loan.

Typically the borrower is either a company (for “corporate bonds”) or a government (for “government bonds”). Ownership of the bond entitles the investor to a regular stream of interest payments and, when the time comes, repayment of the sum lent in the first place.

“When you buy a bond, you’re essentially lending money to the issuer of that bond,” says Ben Gutteridge of fund management company Invesco. “In return, they promise to pay you a fixed rate of interest – also called the ‘coupon’ – over a specified period and to repay the principal amount – or face value – of the bond when it matures.”

Let’s look at an example. Suppose a company wants to expand and decides to raise £5m by issuing bonds. It could sell 5,000 five-year bonds to investors at a face value of £1,000 each and offer an interest rate (or coupon) of 5pc a year in exchange for the money lent to it by the investors who buy the bond.

The investors would receive interest of £50 a year for each £1,000 bond, typically paid in two instalments per year, over the five-year life of the bond. After five years the investor gets his or her £1,000 back and interest payments cease.

“Rather than buying a share of the company, the investor lends the company money,” says Chris Rush of Iboss Asset Management. “The company gains a convenient way to raise funds, while the investor benefits from the interest paid by the company.”

Bonds are considered safer than stocks because, while there is no guarantee that companies will grow, or pay a dividend, they are legally obliged to pay bondholders their interest and, at maturity, the principal.

Therefore, the main risk of holding a bond is the possibility that the bond issuer could get into financial difficulty and fail to make the promised payments.

What different types of bonds are there?

Broadly speaking, government and corporate bonds dominate the bond market, although there are several other types on offer.

We will focus on three main areas: government bonds from developed economies, corporate bonds and emerging market debt (EMD).

Government bonds

These are bonds issued and backed by a country’s central government. In Britain government bonds are known as “gilts” and are backed by the Government’s tax revenues.

Gutteridge says gilts are considered very low risk – in fact the yield on them is often called the “risk-free rate” – owing to the very high probability that the Government will repay its debts.

As a result they typically offer lower interest rates than other types of bond. In America, the largest bond market, government-issued bonds are called “treasuries”, in Germany they are “bunds” and in Japan “JGBs” or Japanese government bonds.

The graph below shows how government bonds have suffered in recent years.

Corporate bonds

After government bonds, corporate bonds have historically been the largest segment of the bond market. These are bonds issued by companies to raise money and they are considered riskier than gilts, as a company’s financial health can fluctuate and affect its ability to repay its debts.

The corporate bond market can be split into two broad categories: “investment grade” and “high yield”. Also known as “junk bonds”, high-yield bonds are issued by companies with lower credit ratings and as a result are considered riskier than their investment-grade counterparts.

“High-yield bonds offer higher potential returns but also have a higher chance of default,” says Gutteridge.

Emerging market debt

Government and corporate bonds issued in developing countries are known as emerging market bonds or emerging market debt (EMD). As the bonds typically come from countries with different growth prospects, they can help to diversify an investment portfolio and can provide attractive returns.

“EMD often offers higher potential returns than developed market bonds, but also comes with higher risks owing to political and economic instability, currency fluctuations and other factors,” Gutteridge says.

Inflation-linked bonds

A specialist sector of inflation-linked bonds – also known as index-linked or “linkers” – pay interest that rises with inflation. Such bonds aim to offer protection when stock markets fall, as well as providing a shield against inflation.

Why hold bonds?

A key reason for investing in bonds is to receive an income. All types of bonds provide investors with a pre-determined interest rate, which for income-seekers, particularly those in retirement, is a tempting offer.

While some of the terminology may seem daunting, Gutteridge says fixed-income investing is for everyone.

Pensioners could benefit from the steady stream of income bonds generate, but bonds also provide balance to portfolios and help investors of all kinds to achieve their goals.

Another reason to hold bonds is the diversification they offer over and above investing solely in the stock market. Diversification is just a fancy name for spreading risk by holding a variety of assets and a key argument for holding bonds is that they can help reduce the risk you are taking overall.

“A key diversifying benefit of a bond is the treatment of bondholders in the event of the bankruptcy of an issuer,” says Gutteridge.

“Of particular comfort to a bondholder would be the higher status they command versus a shareholder: should a company go bankrupt bondholders would typically need to be paid off in full before shareholders received a single penny.”

“The beauty of bonds lies in their predictability,” says Darius McDermott of FundCalibre, a fund rating service.

“Unlike the roller-coaster ride of the stock market, bonds offer a steady, predetermined stream of income. You know what you are getting before you even invest, providing a reliable cushion of stability amid market turbulence.”

However, for those worried about recession, McDermott says government bonds such as gilts and treasuries are the best bet. “Historically, they have a negative correlation with shares at times of stock market stress and therefore can anchor your portfolio should stocks take a dive,” he says.

Both McDermott and Rush from Iboss argue that, despite the lure of high interest rates, keeping all your money in cash is a mistake.

“While interest rates on cash accounts look more attractive than they have for a decade, it is still the case that investing in cash will erode your spending power relative to inflation,” says Rush. “The only way to outperform inflation – and therefore maintain spending power – is to invest in riskier assets.

“Unfortunately, the rather obvious downside of such assets is that they require investors to take risks, a situation that has been relatively uncomfortable since 2022.”

What are the risks of investing in bonds?

When it comes to investing in bonds, the golden rule to remember is the inverse relationship between price and yield. If the yield on a bond goes up, its price goes down, and vice versa.

It’s also vital to appreciate how a bond’s price will move when interest rates change.

“When interest rates rise, bond prices tend to fall, and vice versa,” says Gutteridge. “This is because investors can get a higher return on their money by buying new bonds that pay higher interest rates than by holding on to older bonds that pay lower rates.”

The prices of those older bonds therefore fall, and their yields rise, to compensate. The prices of bonds furthest from maturity are most sensitive to interest rate changes. After all, if a bond is to be repaid in a month’s time, you know you will receive back its face value then, so there is little scope for its price to fluctuate. It’s a different matter if it matures in 10 years.

Another factor to consider is the creditworthiness of the bond issuer. Government-issued bonds are normally perceived to be safer than corporate bonds because there is less risk of default. As a result, government bonds usually offer lower interest rates than their corporate counterparts.

Inflation will erode the value of bonds over time by diminishing the purchasing power of the fixed interest payments, and of the principal when it is eventually repaid.

How to invest in bonds

You can buy government bonds directly through the Government’s debt issuer – the Debt Management Office (DMO) – where they are issued in units of £100.

It provides a trading service, meaning that you can buy and sell gilts that are already in the market. However, to be eligible to use the service you must first sign up as a member of a DMO “approved group of investors”, which is only available to UK residents.

You don’t need to be a member of the approved group to sell gilts via the service, however. For buying or selling, you’ll pay fees of 0.7pc of the value of the gilts you’re trading.

Investing in other kinds of bonds can be complicated, but McDermott says it is not something you need to do all by yourself.

“One option is to invest in a ‘strategic bond’ fund,” he says. “These vehicles have all the bond options at their fingertips to adapt effectively to different market conditions: government and corporate bonds, high-yield and investment-grade, emerging markets and developed markets.

“They can be flexible on currency, on credit risk and on inflation protection. We believe the Baillie Gifford Strategic Bond, Invesco Tactical Bond and Nomura Global Dynamic Bond funds are all robust options.”

Bonds can also be bought individually at the point of issue on the “primary market” through brokerages such as banks, bond traders or stockbrokers. However, Gutteridge says these bond offers can be difficult to access for all but the wealthiest investors.

Brokers also facilitate the buying and selling of bonds on the “secondary market” (in other words, after issuance, when you buy from another investor rather than from the issuer), although Gutteridge warns that challenges for individual investors exist here too.

“They’re often subject to a high minimum investment threshold and high transaction costs, so building a diversified portfolio would require significant investment,” he says.

Outside strategic bond funds, investors also have the option to put their money into a more specialised bond fund such as a dedicated gilt, investment-grade or high-yield bond fund to align with their investment goals and risk tolerance.

Investment platforms, financial advisers or brokerages often provide access to both these and strategic bond funds. The last option is to invest in a “multi-asset” fund, whose manager will decide how much of your money to put into stocks, bonds, cash and other assets.

“While the opportunity in bond markets look better than it has for many years, there will still be volatility and uncertainty over the shorter term,” says Rush.

“However, now that rates are higher, we believe that bonds can offset the risk of investing in stock markets better than in more recent history.”

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