A bond is a loan to a company, government or a local authority. Usually, interest is paid to you as the lender, with the amount of the loan then also repaid to the lender at the end of the term of the bond (typically ten years or less).
There are several other names for this type of investment, for example:
fixed interest (or fixed income);
gilts (loans to the government); and
corporate bonds (loans to companies).
The main benefit of bonds, as a form of investment, is that you normally receive a regular stable income. Bonds are not generally designed to provide capital growth.
Investing in bonds is generally less risky than investing in shares in a company. One of the main risks that goes with buying shares is that if, for example, the company experiences financial difficulties such as insolvency, the company may be unable to pay any dividends, or you might lose all of the money you have invested in their shares.
It is generally considered that the risks outlined above do not apply to the type of bonds known as gilts. A government is expected to always be able to pay the interest as it falls due and repay investors’ loans in full. There have however been instances of some countries having been unable to repay their obligations to lenders and, in recent years, there has been increasing uncertainty as to whether some European governments will be able to repay their borrowings. This is known as sovereign risk.
Bonds issued by governments will usually pay a lower rate of interest than bonds issued by companies as a result of the perception that they are less risky. In the years since the credit crisis factors such as sovereign risk have become a much more significant consideration.
Someone who invests all of their money in equities (stocks and shares) could end up losing a very significant amount if the market suddenly falls by 40% for example. Some of the main reasons why investors hold bondstherefore are to reduce the overall risk of an investment portfolio and to produce a decent level of income.
It also makes sense that people have more of their portfolio invested in bonds the closer they are to retirement age, as there would be less time to replenish savings after a market crash which normally have an adverse affect on equity prices.
Companies have different credit ratings and a company with a high credit rating is regarded as a safer bet than a company which has a low credit rating. Companies with a low credit rating will have to offer a higher rate of interest on their bonds than companies with a higher credit rating, simply to attract investors and to compensate for the higher risk.
Bond prices vary from day to day. A rise or fall in the market price of a bond does not affect what you would get back if you hold the bond until it matures.
At the end of the term of a bond, you will only get back the nominal value of the bond, in addition to any coupon payment to which you have been entitled during your ownership of the bond, irrespective of what you paid for the bond. If you paid less than the nominal value of the bond then you will have made a capital gain when the bond matures. If you paid more than the nominal value, you will make a capital loss.
This only applies if you buy a single bond. It does not apply to bond funds (pooled investments). Because bond funds invest in several different bonds, there is no single maturity date for an investment in a bond fund.
Buying and selling
Bonds can be bought and sold in the market (like shares). If you want to buy bonds directly, you can do this through a stockbroking firm. You will pay charges for this in the same way that you would when buying shares.
Alternatively you can have access to investing in bonds through a pooled investment such as a bond fund.