A bond is simply a loan to an entity, often referred to as the issuer, by someone who wants that money now (the investor) but will give it back at a pre-determined point in the future (called maturity). The difference between what they paid for it (the price) and what they will get back (the value) is called the yield.
This relationship can be plotted on something called a yield curve. The simplest way of understanding this is if you put £100 in the bank right now, you will get back £100 next year. That is a zero per cent yield on your money. If you wait longer, the longer you will receive a higher percentage return on your investment. For example, after ten years, that 100 would be worth about £150 because by then, the interest on that capital has accumulated to 50%* over those ten years.
This relationship between price and yield can be applied to any product with an agreed value at a certain point in time – including bonds! Bonds can have different payment terms, for example, monthly or yearly repayments until the maturity of the loan. The specific details of each bond are published before they become available so investors can decide whether these fit their requirements and expectations for risk and reward. They’re also regularly bought and sold on exchanges and over-the-counter (OTC).
When buying or selling bonds, one of the first things to consider is credit ratings. Credit ratings are scorecards for evaluating how risky it is to invest money in a specific bond. There are three major credit rating agencies that you should be aware o such as S&Poor’s, Moody’s Investors Service, Inc., and Fitch Ratings Inc. They rank with AAA being the safest investment possible through down as far as D, which would indicate an entity was close to defaulting on its debt repayments.
Once you have decided upon the bond, you wish to trade, your broker will assist with buying or selling. You can buy or sell directly on an exchange, but the most popular in the UK is London Stock Exchange and its subsidiary, International Order Book (IOB).
Bonds come with two types of risk: inflation risk and interest rate risk.
Inflation risk is the chance that people will lose faith in the UK’s economy, leading to higher prices which effectively cuts their purchasing power, so they get less money than they put in.
The bonds deliver regular payments, but investors still need to be aware that prices could fluctuate, meaning they get back less than they originally paid for them despite getting regular returns on the amount owed. This means unless you’re expecting inflation for other investments, it can be unwise to hold onto bonds over the long term if there is too much inflation risk associated with holding onto them.
If interest rates fall, the price of bonds go up and vice versa. If you hold them for a long time, there is no guarantee that they will rise in value when inflation goes down or even remain the same, so it’s hard to plan how much money you can make from them.
The UK bonds market is huge and has grown rapidly over recent years. In 2014 it brought in £908 billion in investment compared to £64 billion just four years earlier. As this market continues to grow, we can expect more innovative ways to buy and sell these products, such as online trading or even peer-to-peer lending. As with all investments, conduct thorough research yourself and seek professional advice from a reputable online broker from Saxo Bank before parting with your cash.
To read more on topics like this, check out the Money category