How to invest in bonds: a beginner’s guide

Why do US interest rates and inflation forecasts affect bond yields? We explain the workings of a confusing asset class.

Confucius once famously said: “Life is really simple, but we insist on making it complicated.” Nowhere is this truer than in the bond market.

The essential elements of a bond are straightforward: the buyer of the bond lends money to a company or government for a fixed period of time, and - providing that institution doesn't go bust - they are paid interest and receive their capital back at the end. What could be simpler?

But there are a lot of variables. For example, it is possible to change the length of that loan. If the term changes from, say, five years to 20 years, there is far more time for the company to go bust, for interest rates to change and for inflation to rise.

And how much interest should bond holders receive? Are they paid enough to make it worth their while moving out of cash? Will their payments rise with inflation? Before you know it, the world of bonds starts to look very complicated indeed.

BONDS: THE RISKS

There are a number of key considerations when assessing a bond: notably time, the interest rate, the issuer and the economic environment. Like that of any other asset, the price of every bond will reflect the likelihood of being paid back.

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If there is a greater chance of an investor not getting their money back - a longer time frame or a riskier issuer, for example - they should demand a higher return in order to take the risk.

Elements in the economic environment - higher inflation, stronger growth - will also influence the price investors demand to lend money.

Considering these factors in turn: time is a vital part of any bond. Each bond has a given time until maturity, but the most important measure is “duration”, a slightly different calculation.

BOND DURATION

Nick Gartside, international chief investment officer of the global fixed income, currency and commodities group at JPMorgan Asset Management, says: “In essence, duration shows the average time to get your cash back. The longer a bond, the more riskier it is, because you wait longer to get your cash back.”

Duration will usually be shorter than the maturity date because investors will have got some of their money back from the interest payments. It is important because it measures the sensitivity of individual bonds to changes in interest rates.

Adrian Hull, head of fixed income at Kames, says: “Normally, investors would expect to receive a higher income for investing for longer, though at the moment you don't get much more for investing for 30 years than for 10 years.”

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The bond issuer is also important. Investors demand more to lend to less trustworthy borrowers where there is more chance they won't get their money back at the end of the term. There are two main types of bond issuer - governments and corporates.

The price of a government bond is largely influenced by expectations of interest rates and inflation.

INTEREST RATES ARE A THREAT

Gartside says: “Bond investors have two enemies: higher growth and higher inflation. In this type of economic environment, central bankers are much more likely to raise interest rates. This is usually bad for bonds - if you can get higher returns on cash, why own a bond?”

At the same time, inflation makes the repayments you receive on the bond less valuable.

Corporate bonds will also include a “spread” over government bonds to reflect the greater risk involved in investing in a company - which must rely on earnings and cash flow to repay the bond - over that of investing in a government, which uses tax receipts.

“This spread will reflect the riskiness of the corporation. Apple will be very highly rated, so the credit spread will be low.

“A 'junk bond' (issued by a company considered a riskier proposition), on the other hand, might have a coupon 4% higher than that of a government bond,” says Gartside.

Hull points out that the economic environment will also have an impact on credit spreads. “In a better economic scenario, credit spreads will probably be tighter, because there is less chance that the company will default.”

That said, he adds that a buoyant economic environment may sow the seeds for problems later: “If credit spreads are tighter, companies might be encouraged to borrow more money, make more investments and buy back shares. This can be bad for credit spreads over the longer term.”

EMERGING MARKET BONDS

Emerging market bonds are a little different. Built into the bond will be some reflection of the higher risk inherent in emerging market economies.

Their economic growth is not assured: they may be vulnerable to the fortunes of just one or two industries, and some are prone to political crises.

While some bonds are issued in “hard” currencies (dollar, euro, yen), others are issued in local currencies, which introduces an added risk. Investors can lose on both the currency and the bond itself, so issuers tend to pay higher interest rates to compensate.

The coupon is the interest paid on a bond and it will reflect the relative risk of the institution that issues the bond.

The UK government doesn't have to pay very much because it is considered likely to repay; smaller, highly indebted countries will have to pay a higher income to encourage people to lend to them.

The coupon will also reflect the prevailing interest rates. If interest rates and therefore rates on cash savings are high, coupons need to be higher to encourage people to invest.

Coupons may also include some indexation - the interest payments from index-linked bonds will rise in line with inflation. As such, the price of the bond will vary in line with inflation expectations.

The yield is the amount of return that an investor earns on a bond; in essence, the coupon divided by the price of the bond. When a bond is bought, the yield will be equal to the interest rate, but it changes as the bond matures and its price varies.

HOW TO CALCULATE A BOND YIELD

There are different types of yield calculation. “Yield to maturity” gives the annual return if the bond is held to maturity and all interest payments are reinvested at the current yield. It also factors in any capital gain or loss at redemption.

“Running yield” takes no account of the capital loss or gain on redemption. It simply gives the bond yield each year, similar to a dividend payment. Investors may also hear the term “nominal yield” - effectively the same as the bond coupon.

The secondary market versus the primary market is also a consideration. Many investors assume that fixed income managers simply buy the bond when it is issued (the primary market) and hold it to maturity, receiving their money back at the end.

In practice, managers of fixed income funds seldom do that; instead they buy and sell their investments in the secondary market.

Gartside says: “For institutional managers it is very rare to buy a bond and sit with it until it matures. The fixed income market is very tradeable and we may want to move to, for example, shorter-dated bonds if the environment is changing.”

This is key to understanding the more apocryphal predictions made for the bond market.

Yes, if the yield on a 10-year gilt rises from 0.5 per cent to 1.5 per cent, that is a meaningful drop in price for those who wish to sell in the secondary market, but they don't have to do so. They can simply keep receiving the same coupon rate until the bond matures.

ASSESSING CREDIT RISK

Rating agencies also play an important role in bond markets. A little like grading homework, ratings agencies assign a rating to a bond based on its creditworthiness.

Different ratings providers have different systems - AAA to C, for example. However, most fund managers worth their salt do not rely solely on the rating given by the rating agency.

Gartside says: “If you are lending money, you want to verify that the issuer has the ability to repay. We have teams of credit analysts who create an independent assessment.”

As if that wasn't complicated enough, the central bankers have thrown a spanner in the works. Quantitative easing (QE) involves the central bank buying government and corporate bonds.

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They have targets for the amount of bonds they need to buy and therefore create a price-insensitive source of constant demand in the market, which affects the price.

Although individual bonds are available for purchase on the major investment platforms, they are not a natural area for the hobbyist as minimum investment levels are high, at around the £100,000 mark.

Bond funds come in many hues, specialising in corporate or government bonds, emerging markets, or a “go-anywhere” strategic approach. If inflation rises, the environment for bonds may be about to become very much more difficult.

WHAT DOES IT MEAN FOR BOND YIELDS?

One key thing to remember is that a rise in the price of a bond means a fall in the yield and vice versa.

Inflation

Bonds usually pay a fixed income, which won't rise with inflation. That means the income becomes less valuable if inflation rises. When bond prices fall, yields rise.

Deflation

Bonds' fixed coupons become much more valuable in a time of falling prices.

Higher interest rates

If investors can get, say, 5% on their savings (remember those days?), they have less incentive to invest in a bond. Coupons need to be higher to encourage people to lend.

Quantitative easing

QE has the effect of creating more demand for certain types of bonds. The central bank is a price-insensitive buyer of higher-quality corporate and government bonds. This pushes up demand, so prices remain high and yields low.

Recession

A recession is usually accompanied by falling interest rates and potential deflation. This is a good environment for bonds. Yields fall and prices rise.

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