Have you wondered what it might be like to “be the bank”, when lending money? With bonds, you can do just that. In effect, when you buy a bond, you lend to a Government (or business) on the understanding that they will repay you at the maturity date (e.g. in 10 years’ time). In the meantime, you receive interest payments (“coupons”) periodically – say, once every 6 months.
For many investors, this asset class is an attractive option when building a portfolio. Yet what are the different types of bonds, and how do they work? How can bonds feature within a wider investment strategy? Let’s turn to these questions below.
Types of bonds
Bonds can be divided into various different categories. First of all, there is, of course, a lending risk for the investor which may be lower/greater depending on who is asking for the money. This is where credit agencies come in – such as Standard & Poor’s (S&P), Moody’s Investor Services (Moody’s), and Fitch IBCA (Fitch). These companies “rate” different bond issuers to indicate the level of risk involved for investors. For instance, a “AAA” rating is considered the best, whilst “C” rated bonds are regarded as higher risk (and so are often called “junk” bonds”).
Secondly, bond issuers can be divided into corporate and governmental. The former are issued by companies and the latter by national governments. Neither is inherently more risky than the other. Indeed, certain companies may have a better bond repayment track record than many governments! The major difference is that Governments can print money or raise taxes to repay debt, whereas Corporates cannot. Bonds can be bought individually by investors or collectively, via bond funds. Most retail investors will purchase the latter when including bonds in a portfolio.
Finally, bonds can be classed either as “normal” or “inflation-linked”. An illustrative example can help show the differences, here. With the former, suppose you bought a 30-year bond in 1998 for £100, with a 5% coupon (paid twice per year). In 2028, when the bond matures, you will get your £100 back and, twice per year in the interim, you get a fixed £5 coupon. However, with an inflation-linked bond, differences would include the coupon rate (i.e. it would be lower) and the semi-annual coupons would rise/fall with the rate of inflation. When you get the principal back in 2028, moreover, this will also rise with inflation so you get your £100 back, in “real value”).
Bonds & investment strategy
These features raise a number of additional questions for investors. What percentage of your portfolio should comprise bonds (versus, say, equities)? Which types of bonds should you put inside? Here, two crucial factors are your risk tolerance and your investment horizon.
Concerning the former, if you feel highly averse to the idea of your investments going up and down a lot in a short period of time, then bonds can hold a lot of appeal. Whilst stock market investments tend to offer better (i.e. higher) long-term returns, they are often volatile in the short term. Bonds tend to be much more stable in the short-term.
On the latter, you need to consider how long you plan to invest (and how this relates to your goals). For instance, if you are nearing retirement then you likely want to focus more on wealth preservation rather than growth. Moreover, you may also want some of your portfolio to produce a regular income. In which case, bonds can be an attractive option. However, if you are early in your career and want to build wealth over, say, 30+ years then holding lots of your portfolio in bonds may not be a “bold” enough investment strategy. Instead, high-growth-potential equities may be a better route to reach your goals (assuming you are happy with the risk involved).
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This content is for information and inspiration purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice regarding your affairs please consult us here at WMM (financial planning in Oxfordshire).