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Learn about bonds

Welcome to the bond markets.

The sterling fixed income markets offer investors a wide choice of assets ranging from the security of government-backed Gilts through to more speculative, and higher yielding corporate bonds.

For the past few decades, these markets have largely been the preserve of institutional investors. The situation is now changing. ISAs and SIPPs are increasing the demand from private investors for income-producing assets, and new ways of buying and selling bonds means they have never been more accessible.

This section of our website aims to help you understand and use this important asset class. Neither income or capital is guaranteed, the value of investments can fall as well as rise and you could get back less than you invest. Tax rules can change and the reliefs depend on your personal circumstances. Corporate bonds may not be suitable for all investors, if you are unsure of their suitability please seek advice.

Types of bonds

Bonds are investments representing the debt of a government, company or other organisation. Effectively they are loans, or "IOUs" issued by these organisations and bought by banks, insurance companies, fund managers and private investors.

Investors are often heard to say "I don't understand bonds", but the truth is they can be much simpler than shares. The key factors can be broken down as follows:

  • Issuer - This is the entity which is borrowing the money. For instance, £500 million will be borrowed, and £500 million of securities will be issued by the issuer. Typically these will be launched at "par" or 100p in the pound.
  • Coupon - The issuer commits to pay a rate of interest of "X" % per year. This coupon will generally be a fixed amount and is paid annually or semi-annually.
  • Maturity - A date is set for the repayment of the money. This is known as the maturity or redemption date. The bonds will be redeemed at "par" or 100p in the pound (with some rare exceptions). However, if the issuer fails you might lose some or all of your investment and the income could stop.

At launch, bonds are sold to investors via an investment bank or broker. This is known as the primary market. Gilt issues are also offered directly to the general public. After this primary phase, bonds can be traded between investors and/or market counterparties. However, unlike equities that trade through a centralised stock exchange, bonds generally trade on a peer-to-peer basis from one institution (such as an investment bank) to another (such as broker).

This global bond market is enormous. The number of bonds in circulation is considerable, and issuers like the European Investment Bank may have several hundred bonds trading at any one time. These bonds will be issued in a variety of currencies and may differ greatly from each other in terms of coupon or coupon type, date of maturity and other features such as embedded put and call options.

Gilts or UK government bonds

These bonds are issued by the UK government in order to finance public spending. Gilt prices will fluctuate from day-to-day in the market, depending on the outlook for interest rates but investors who buy at par or below, and hold the bonds to maturity can be almost certain that interest and principal will be repaid in full, whereas if you buy above par and hold to maturity you will suffer a capital loss despite the government backing.

Conventional Gilts

The majority of Gilts pay a fixed coupon (generally twice a year) and mature at a set date. The life of these instruments will vary from a few months to over forty years. The most popular Gilts for private investors are maturities between two and ten years. Some Gilts have more complex features such as "calls", which enable the government to pay off the debt ahead of time. Before purchasing a Gilt, it is worth checking the full details of the issue. Please note, prospectuses for Gilt issues can be obtained at the website of the government's Debt Management Office.

Index-linked Gilts

First issued in 1981, rather than paying a fixed coupon and amount on redemption, Index-linked Gilts' semi-annual coupon payments and principal are indexed to the UK Retail Prices Index (RPI). It is worth noting that there is a time lag on the RPI used to calculate the coupon and redemption period, however these instruments do offer a shelter against inflation. Because of the inflation-linking aspect of these bonds, Index Linked Gilts may show a wider movement of price over time.

Undated or perpetual Gilts

Undated/perpetual Gilts have no set maturity date; they may (or may not!) be paid back at a time of the government's choosing.

Because of this, holders are reliant on the market price to sell, and as such they are more volatile and more risky than conventional gilts. The most well known amongst this group is the UK 3.5% War Loan.

Sterling denominated non-Gilt

This asset class covers the majority of GBP-denominated bonds other than UK Gilts.

These bonds may be issued by a variety of different types of issuers, including foreign governments, UK banks and medium-sized companies. As with Gilts, bond prices will move alongside the market's expectations for interest rates. However, the price (and thus the yield) will also be affected by the perceived credit quality of the issuer. If this is thought to be deteriorating, the price of the bond will fall.

Retail Bonds

These bonds are specifically issued for retail investors. They are denominated in pounds sterling (GBP) and can usually be bought in relatively small increments (typically £1,000). Like conventional bonds, retail bonds may be issued by a variety of issuers.

Retail bonds will be listed on the London Stock Exchange's Order Book for Retail Bonds (ORB) and can be bought and sold during normal London Stock Exchange opening hours. A retail bond's price will be affected by expected interest rate movements and also by the perceived credit quality of the issuer.

PIBS (Permanent Interest Bearing Shares)

These are a type of instrument issued by UK building societies. Technically they are not bonds and usually carry a degree of subordination (rank below other debt owed by the issuer in the event of default). However, because of their fixed coupons they behave in a manner similar to bonds. Individual issues vary greatly and prospective clients should make sure they read the prospectus from the relevant issuer.

Other types of bonds

Floating rate notes

These are bonds where the coupon is not fixed, but based on a reference rate, typically LIBOR. They do not exhibit the same degree of interest rate sensitivity as conventional bonds. The majority of floating rate loans (FRNs) will be issued with maturities between two and ten years and will be senior debt. However, there is a class of perpetual FRNs which you may encounter from time to time of which the majority are subordinated debt (rank below other debt owed by the issuer in the event of default).

Convertible bonds

These are bonds where the holder may convert his redemption proceeds into the equity of the issuing company. Known as "equity convertibles", they can offer a combination of yield and growth for investors. These instruments may see their price driven higher by a rise in the company's equity. Risk, however, is generally higher.

In some cases, bonds may be issued with the option to convert into other bonds. These are a rather different kettle of fish and should not be confused with the "equity convertibles" above.

Subordinated bonds

The majority of bonds issued are "senior debt", meaning the holder has a priority claim on the company's assets, ahead of shareholders in the event of the company being liquidated. Some bonds are issued with "subordinated" status. This means the buyer of the bonds accepts a lower claim on the company's assets, below senior debt holders, but still above shareholders. Because of the additional risk, a higher yield will be offered.

Why consider bonds

Shares and bonds are very different kinds of investment. Shareholders own the company, bondholders simply lend it money. This means the risk/reward profile is very different. Bondholders just need the company to have enough cash to repay the loan and service the debt. Profits could halve, ordinary dividends could be slashed but, as long as the company can meet its obligations to bondholders, they should continue to receive a fixed rate of interest and their capital back at redemption. In terms of risk and reward, therefore, bonds generally sit between cash and shares.

Security

The risk of the UK or other major governments being unable to repay their debts is low and government bonds should be considered superior in credit quality to a bank deposit in theory. In practice though the government underwrites bank deposits putting them on a par. High grade multi-national government agencies (such as the World Bank) also offer an extremely safe home for the investor holding bonds to maturity. Of course, not all bonds are issued by governments. Many bonds are issued by companies and other organisations whose ability to service the debt may be less certain. However, even corporate debt can be considered a safer investment than the company's equity. In the event of bankruptcy, bondholders are ranked above shareholders in their claim on the company's assets. However, if the company can't meet its obligations to bondholders, their capital and income is at risk.

Return of capital

Bonds also differ from equities in one other very important aspect. In order to realise your profit (or loss) on an equity, you are wholly dependent on the ability to sell the shares back to the market. When an investor buys a bond, the redemption date and value is fixed in advance. Assuming the issuer is able to repay, the investor's reliance on the uncertainties of future market sentiment or liquidity is reduced.

Income

Bonds can add reasonably reliable income to a portfolio. The income available from bonds is generally higher than that available from equities. Also, future income payments are a relatively known quantity, unlike dividends from shares, which may be reduced or stopped in times of low profitability. This generally makes bonds a good choice for investors who wish to shelter future income over a defined period of time. With bonds paying annually, semi-annually or sometimes quarterly, a carefully chosen bond portfolio with multiple holdings can produce a reliable monthly income. Remember also that most bonds pay their coupons gross, without withholding tax. Investors can take advantage of this by holding qualifying bonds within an ISA, producing a tax free income. Remember tax rules can change and the reliefs depend on your personal circumstances, also that the income is not guaranteed and is dependent on the ability of the issuer to pay.

Diversification

A well-managed portfolio should contain a variety of different assets classes. Equities, government bonds, index-linked bonds, corporate bonds, and alternative assets all have their role to play. This simple approach of diversifying a portfolio is one of the most effective strategies for reducing risk. In certain economic scenarios, such as a recession, some bonds will offer a shelter against falling share prices.

Interest rates

When an investor buys a fixed coupon bond, they lock in interest rates for a defined period. If interest rates rise, the income from a bond becomes less attractive and the market value of the bond will fall. Falling interest rates will cause the market value of the bond to rise. Investors who buy bonds in falling interest rate scenarios will receive the double benefit of a secure income and capital appreciation of their asset. Investors must note that interest rates are at an all time low and can only really rise from here.

Speculation

Any financial instrument offers the potential to speculate on future price movements, and bonds are no exception. Liquid government bonds are often used by traders speculating on future interest rates while corporate bonds can see sharp price movements from changes in the perceived credit quality of the issuer.

Types of bonds

All investments involve risk, and bonds are no exception. Investments can fall in value as well as rise and you could get back less than you invest.

Risk of default

There is a risk that the issuer will be unable to return all or some of the capital and interest payments. In the bond markets this is known as a default. The equivalent in the equity market would be a company going bust, ceasing to trade, or being forced into administration.

Market risk

The bond's price will fluctuate from day to day according to the balance of supply and demand in the market, creating a paper profit or loss. Thus, if the investor needs to sell the asset before maturity to raise funds, there is a risk of capital loss.

Issue-specific risk

Many bonds are issued with imbedded features such as "calls", which enable the issuer to repay the debt ahead of schedule. This can be disadvantageous to the holder. Such features are clearly laid out in the bond's prospectus, investors should make sure they read a bond's prospectus prior to investing. If you are unsure of the suitability of an investment please seek advice.

Event and other risks

This encompasses a variety of "operational" hazards such as a shift to an unfavourable or punitive tax treatment, remember tax rules can change and any reliefs depend on your personal circumstances. These types of risk can be reduced through careful planning and monitoring. Next we have "event risk". An example of this would be the issuer of the bond becoming the target of a leveraged buyout - a buyout where by the company taking over the issuer is buying with the use of debt, increasing the degree of risk of lending money to the company. Finally, we add to this list the risk of inflation, which can devalue the asset or portfolio over time.

Frequently asked questions

  • Are bonds more, or less risky than equities?

    It is fair to say that bonds are generally less risky than equities. Price volatility in bonds is generally lower than that seen in equities. Risk adverse bond investors should restrict themselves to gilts and investment grade bonds and run a diversified portfolio.

  • Are some bonds more risky than others?

    Yes. Some issuers are more credit-worthy than others. For more on this subject see "Credit rating explained". Also consider that the longer until the maturity date of the bond, the more you are a hostage to the future movement of interest rates and inflation.

  • What happens if the issuer of the bonds goes bust?

    In this event the issuer may be unable to pay the coupons or the capital (principle). However, the bond holders will have at least some priority over the assets of the issuer, ahead of the holders of ordinary shares.

  • Are there any other risks that I should be aware of?

    Inflation is a major risk. Over longer periods of time this may erode the return of a bond portfolio, causing the value to fall in real terms. The outlook for inflation will have an impact on the market value of the bond and therefore if you sell before maturity it will impact on the value.

    The prospectus for each bond will contain further details of risks.

Credit ratings

Credit quality is a measure of the issuer's ability to service and repay its debt. Investors may have their own knowledge and views on a company's ability to repay debt or, alternatively, they can view the credit rating assigned to issuers by several of the credit rating agencies. Credit agencies deploy considerable resources to assess both the issuer and the individual bond. It is in the interest of bond issuers to obtain these ratings. That said, it is the company itself which pays the ratings agency to rate their bonds and that does create a potential conflict of interest. There are two main international credit ratings agencies, namely Moody's and Standard & Poor's.

Credit ratings are used by most banks and fund managers when establishing the suitability of a bond as an investment but, remember, situations change quickly, and so can credit ratings. You can look up the rating of most bond issuers on the Moodys and Standard & Poors websites. Much research on this subject is also conducted by broking houses and investment banks, as well as some good up and coming independent analysts. However it is worth bearing in mind that movements in the issuers share and bond prices will usually occur prior to any change in the credit rating.

Here is Standard & Poor's definition of the ratings it awards to organisations issuing bonds (a conversion table for Moody’s and S&P is shown on the right):

Standard & Poor's Moody's
AAA
Aaa
AA+
Aa1
AA
Aa2
AA-
Aa3
A+
A1
A
A2
A-
A3
BBB+Baa1
BBB
Baa2
BBB-
Baa3
BB+
Ba1
BBBa2
B
Ba3

AAA - Extremely strong capacity to meet its financial commitments. AAA is the highest issuer credit rating by Standard & Poor's.

AA - Very strong capacity to meet its financial commitments. It differs from the highest rated obligors only in small degrees.

A - Strong capacity to meet its financial commitments, but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

BBB - Adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.

The above credit ratings are known as 'investment-grade debt'. As a rule of thumb, investors managing portfolios where the risk should be relatively low, and security of income and capital is more important, will restrict themselves to bonds rated AAA and AA, with perhaps a few single A investments. Consider also a bond's credit history. Has the rating improved or declined over time? Bonds subject to a potential re-rating will be on 'credit watch'.

Below BBB - Bonds rated below BBB are known as 'non-investment grade', 'high yield' or, less charitably, as 'junk' bonds. These bonds are of a more speculative nature, and imply a certain degree of risk. In view of this, the incremental yield available on the instrument must be adequate to compensate the investor for this risk. Standard & Poor's gives the following definitions for non-investment grade debt.

BB - Less vulnerable in the near term than other lower-rated obligors. However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions that could lead to the obligor's inadequate capacity to meet its financial commitments.

B - More vulnerable than the obligors rated BB, but the obligor currently has the capacity to meet its financial commitments. Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments.

CCC - Currently vulnerable, and is dependent upon favourable business, financial, and economic conditions to meet its financial commitments.

CC - Currently highly vulnerable.

C - May be used to cover a situation where a bankruptcy petition has been filed or similar action taken, but payments on this obligation are being continued. C ratings will also be assigned to a preferred stock issue in arrears on dividends or sinking fund payments, but that is currently paying.

Plus (+) or minus (-) The ratings from AA to CCC may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories.

Types of issuer

Before we go on to look at some examples of individual bonds and their credit ratings, it is worth considering the different classes of issuer that one might be likely to come across in the Sterling bonds markets:

As a rule of thumb, the bonds with the least risk of default are the high quality sovereign issuers such as the UK and the larger and wealthier European countries. The risk of default* for bonds issued by these countries can be assumed to be low, and less than the risk from a bank deposit. Ranking alongside these are the Supranationals, these being agencies such as the World Bank and the European Investment Bank which are supported by their sovereign members.  

Second to this are the second-line countries, and those experiencing some economic difficulty. Here we would give Italy and Japan as two examples. While these countries do not quite have the economic strength of some of their peers, this type of debt should not be confused with emerging market bonds, which carries a much higher degree of risk. 

Finally we have corporate bonds. These are bonds issued by corporations, typically large quoted companies. The life of a company is full of ups and downs and it is fair to say that in most cases corporate bonds carry a greater risk than those issued by major governments or banks. Factors affecting a company's credit rating include cash flow, profitability, asset valuations and unforeseen events such as legal action, a takeover or a change of the trading environment. The yield on these bonds will normally be greater than that available on bank debt.

Other types of issuers: There are numerous bonds issued to fund mortgage loans, credit card loans and other more complex financial transactions. These types of bonds, often known as mortgage-backed securities (MBS) and asset-backed securities (ABS) are not generally available to the investing public in the UK. The credit quality of these can vary and investors should be sure of their suitability before buying.

*Note: risk of default should not be confused with market risk, or price volatility. A bond can be 100% guaranteed by all the governments in the world and still experience price swings between issue and redemption, typically driven by changing interest rate volatility.

Some sample issuers and their ratings

Here we have taken a few of the popular issuers:

AAA - Germany and Australia. Supranational agencies such as the European Investment Bank (also known as the EIB).

AA - Sovereigns such as France and Japan. A few high quality banks and corporates.

A - Good quality corporates. Lower rated banks.

BBB - More speculative corporates.

Note: These samples are based on the rating in force in November 2015, and are subject to change.

Frequently asked questions

  • Will a highly rated bond be less volatile than a lowly rated bond?

    To a degree, yes. The perception of risk will tend to fluctuate less. However, the influence of interest rates, both in the present and to come will exert a similar influence on both highly and lowly rates bonds alike.

  • What are 'junk bonds'?

    The expression 'junk' bond is an informal term for a non-investment grade bond, i.e. a bond that is rated below BBB-. In truth the term junk is often a rather harsh description and the majority of these bonds will live a useful and uneventful life, servicing both coupons and redemption payments. Nevertheless, a risk of default is implied in the name and caution should be applied when dealing in these assets.

  • Can credit ratings change?

    Yes, although the ratings that we follow are described as "long term ratings" by the two main agencies, they can swing around quite quickly as perceptions change. An example of this was the sovereign state of South Korea, downgrade from a comfortable AA- to a worrying BBB- in the late 90's. Corporate bonds are even more subject to change as their issuers may be impacted by adverse trading conditions. Leveraged takeovers, in particular, can have a sudden and disastrous impact on credit ratings.

Yield of bonds

Investors will generally buy a bond for two reasons. The first is to lock-in a known future income stream. The second is to attempt to benefit from rising bond prices. But what would cause the value of a bond to rise? As with all traded assets, it will be down to supply and demand. There are two main variables affecting the price of bonds, the first being interest rates and the second the perceived credit quality or risk of default for the bond. Let's consider the effect of the former on bond prices. As interest rates fall, a bond paying a fixed rate of interest every year will become increasingly sought after by investors. Conversely, rising interest rates, perhaps accompanied by inflation, will make the fixed income stream unattractive to investors and the market price will fall. This relationship between price and yield is the key to understanding the factors moving the fixed income markets.

Price and yield

To understand the return on fixed income instruments is to view a bond as a series of discounted cashflows. At the start of the period, the investor pays out cash to purchase the bond. Over the course of the bond's life, the investor should then receive several payments, usually one or two a year from interest payments and a final repayment at the end of the bond's life-span. In this respect, bonds differ fundamentally from equities, where the future cashflows are unknown.

Given future cashflows are known quantities, the relationship between the price of a bond and its yield is governed by mathematical formulae. We are going to look at three methods of analysing a bond's yield; the income yield, the simple yield and the yield to maturity (YTM).

Income yield

Imagine a bond with a 5% coupon (divided into two semi-annual payments) maturing on 7 September 2020. If you bought the bond at the face value of 100p or "par", we know we would receive an income 5% per annum on our investment until maturity.

But what if you paid less than par for the bond? Assume we purchase the same bond for 95p. Our income (or "running") yield would be:

Par/purchase price * coupon = running yield

Or 100/95 * 5% = 5.26% per annum.

Buying a bond above par has the effect of reducing the bond's income yield. If you bought the bond above for 112p the income yield would drop to 4.46%.

100/112 * 5 = 4.46% per annum

The income or running yield (sometimes also known as the flat yield) does not take into account any profit or loss made by holding the bond to redemption, and simply assumes the investor will be able to sell the bond at the same price they purchased it for. For a more accurate measure of yield, we must turn to the yield to maturity, the standard calculation employed by market professionals, also known as the redemption yield.

Before we turn to the more complex (and more accurate) yield to maturity, it is worth considering the "simple yield". This is a good rough guide to the return available on a bond, and can often be worked out in one's head.

Simple yield

Let us take another theoretical bond with one year left to run until redemption. The bond has a 4% coupon and we have purchased it in the market for 97p. Our return consists of two factors, the running yield over the 12-month period and the profit made on maturity. Assume we buy £1,000 nominal. Thus, from our initial investment of £970, we will receive the following:

£40 coupon payment (our running yield)

£1,000 redemption payment (a £30 profit)

Our return over the twelve month period is £70 on £970, or 7.2%.

From the point of view of the private investor, this type of calculation is perfectly adequate for assessing the return on a bond. Known as the simple yield, the formula can be expressed as follows:

(Annual coupon / Market price + (par-market price) / Market price) * 100

Yield to maturity (YTM)

With longer dated bonds, the same theory applies, but to gain a more accurate measure, we must discount each future cash flow according to when it will be paid. The formula used to calculate this is known as the yield to maturity (YTM) and is effectively the internal rate of return on the investment, allowing for each and every cash flow. The calculation assumes that the company cannot only meet its obligation, but that the interest payments received on the bond can be reinvested at the same rate, although this may not be the case in real life.

The formula for this calculation is somewhat of a handful, and certainly not one for mental arithmetic. For readers who enjoy a challenge, it is:

Price = Coupon * 1/r [1-1/(1+r)n] + Redemption/(1+r)n

YTMs may be calculated by using the YIELDMAT function on Microsoft Excel or on a dedicated financial calculator such as a Hewlett Packard 12C or 17B.

Why does the price of some bonds move more than others?

Using the example of our theoretical 4% bond with 12 months left to run until maturity, a 1% shift in the yield demanded by investors will produce a change in price roughly equivalent to 1%. In the case of a longer dated bond, with many more years to run until redemption, the price move will be considerably more. This relationship between a given change in yield and the resulting change in price is known as the duration of the bond. Duration will have a considerable effect on the volatility of the asset over a range of different interest rate scenarios. Let's take three UK Gilts as an example (calculations based on figures from June 2013).

Bond Duration Current price Current YTM Price if YTM
0% 1% 2% 3% 4% 5%
UKT 2.75 1/22/15 1.6 103.8 0.4 104.48 102.8 101.2 99.6 98 96.5
UKT 1.25 7/22/18 5 100.8 1.1 106.4 101.2 96.4 91.7 87.4 83.2
UKT 1.75 9/07/22 8.5 97.6 2 116.2 106.6 97.9 90 82.7 76.2
UKT 3.25 1/22/44 19.2 97.6 3.4 199.6 159.2 128.5 105 86.8 72.7

Note that the higher the duration of the bond the greater the price move shown per change in yield. Duration is governed by the length of time to maturity and the size of the coupon, in effect, the average period of all cash flows. A long dated bond with a low coupon will have the greatest duration, a short dated bond with a high coupon will have the lowest duration. Investors looking to benefit from falling yields should look to add duration to their bond portfolios, defensive investors, or those envisioning a rising interest rate scenario will look to reduce it.

The relationship between price and yield for a corporate bond is exactly the same as a government bond, and the same yield calculators can be used for both. However, compared to a safe government bond, investors will demand an additional return for lending money to corporations due to the increased risk of default. This premium over the equivalent government bond yield is known as the spread.

Non-government bond spreads vary greatly, with supranational agencies (such as the World Bank) trading at only a tiny fraction over governments while the debt of smaller, risky or unfashionable companies may trade at a level returning several percent or more over a government bond of an equivalent maturity.

Remember, corporate bond spreads reflect the market's view of the creditworthiness of the issuer. This opinion can change quickly, adding price volatility to this type of bond over and above that determined by interest rate fluctuations.

The yield curve

Both government and corporate bonds are issued in a variety of maturities, ranging from super-short 3-month treasury bills and corporate paper through to 30 year or even undated or “perpetual” bonds with no final maturity.

Interest rates change over time, and bonds of different maturities will have different yields, reflecting the market's expectations for future interest rates. Generally, investors will require an incrementally higher yield for longer dated securities. This means that long dated bonds generally yield more than short dated bonds. This is known as a “positive yield curve” and is the usual state of play in the markets. If investors expect interest rates to rise in the future, the price of longer dated bonds will fall, pushing up yields at the long end of the curve. This is known as a “steepening” of the yield curve.

Alternatively, the perception of falling interest rates can lead to an “inverse” yield curve, where investors scramble to lock in fixed rates at the long end, pushing yields down below current money market rates.

Buying and selling bonds

Identifying your bond

Once you have determined which bond or bonds to buy, it is important to correctly identify it to prevent errors in dealing or other misunderstandings. Each issuer may have several bonds trading in the market at any given time. Market convention describes bonds in the following notation: issuer, coupon, maturity. Thus, the BT bond illustrated below would be described as the "British Telecommunication eight and five eighths percent 26th March 2020".

Issuer Coupon Date Life Price Yield
British Telecommunication PLC 8.625% 26 Mar 2020 6yrs 10mths 137.47 2.565%
 

What will the final cost be?

The price you see on the screen is known as the "clean" price of the bonds and on this basis an investor buying £10,000 of bonds at a price of 99.30 will pay £9,930. However, we must also consider the factor of any accrued interest.

What is accrued interest?

If an investor buys a bond on its first day of issue, or just after the last coupon payment, the price seen on the screen will be the full price. However, when buying a bond part way through its coupon period (for instance 6 months after the last coupon payment for an annual bond), there will be an adjustment for the income that has "accrued" to the bond. This is standard practice in the bond market and strikes a fair balance between buyers and sellers, as well as neatly differentiating between cash flows from income and those from capital gains.

With the majority of non-Gilt bonds, the basis of this accrued interest is calculated on a "30/360" basis. This assumes that each month has 30 days, and each year has 360 days. Thus, let us assume that we are buying £10,000 nominal of the British Telecommunication 8.625% 26 March 2020 as of (28 May 2013). The market price is 137.81p and the trade is for settlement in three business day's time.

£10,000 nominal of British Telecommunication 8.625% 26 March 2020 @ 137.81 = £13,781

The settlement date is 31 May 2013. The bond pays a coupon annually and the last payment was on 26 March 2013.

26 March to 31 May = 64 days on a 30/360 basis

So, the accrued interest will equal 64 days / 360 days times the annual coupon, times £10,000 nominal, or:

64/360 x 8.625/100 x £10,000 = £153.33

Thus, our contract note will show roughly the following:

£10,000 nominal of British Telecommunication 8.625% 26th March 2020 bonds @ 137.81 £13,781
Accrued interest £153.33
Commission £50.00
Total £13,984.33

Note: The price shown on the screen will not include accrued interest and will be known as the "clean price". The effective price that you pay, including any accrued interest is known as the "dirty price"

Accrued interest for Gilts

The Debt Management Office produces a detailed document on calculating the accrued interest on Gilts which can be downloaded from their website. This covers the subject in detail, including the complex calculations performed on index-linked Gilts.

At the risk of oversimplifying the subject, the main variations from the calculation process shown above are as follows:

  • Most Gilts pay coupons twice a year (the majority of non Gilts pay annual coupons). The exceptions to this rule are some of the undated bonds such as 2.5% Consuls.
  • The accrued interest is calculated on "actual/actual" basis, where the true number of calendar days is used to determine the apportionment of the coupon.

Selling your bonds

The normal strategy for investing in bonds is typically "buy and hold". Remember, unlike equities there is no need to sell in order to realise your investment; capital will be returned to you on maturity.

However, from time to time investors need to sell a bond in order to raise capital, or perhaps to switch into other investment opportunities. In the event of this, bonds can be sold back into the market. Please note this market price may be higher or lower than your purchase price and this will impact the return you receive on the investment.

When selling a bond, the accrued interest must also be factored into the calculation. In this case, any unpaid interest will be paid over from the new buyer to the seller, effectively the reverse of the scenario illustrated above.

Here we seek to address some frequently asked questions about corporate bonds and Gilts.

If you're unable to find what you're looking for, please do not hesitate to call our Investment Helpdesk on 0117 900 9000 or email us.

  • Can private investors trade bonds?

    Yes, but the nature of the instruments makes them better suited to a "buy & hold" strategy. If you are unsure of their suitability please seek advice.

  • Do I need a lot of money to trade bonds?

    If you invest in small sums, the returns may be diminished by dealing cost. Bonds traditionally have minimum investments of £1,000 (nominal), although some bonds can have minimums that are significantly higher.

  • I own various bonds in my portfolio, why are they not shown on this website?

    There are thousands of Sterling denominated bonds. Not all of them are liquid and we are unable to display accurate price data for all of them. The bonds displayed are selected based on considerations of quality and liquidity. To deal in bonds not shown on this list, please contact us.

  • Are credit ratings displayed on the website?

    At present, credit ratings are not displayed on the website.

  • Can I put bonds in my ISA?

    Yes, however HM Revenue & Customs rules state that in order to be eligible for holding within a ISA, the bond should be listed on a recognised stock exchange, or the bonds must be issued by a company which is itself listed (or a major subsidiary thereof).

  • Can I put bonds in my SIPP?

    Yes, the majority of SIPP schemes allow you to hold bonds. There is no theoretical barrier, however the bond must be listed on a stock exchange.

  • If I sell my bonds before the coupon pays out, will I miss out on the interest?

    No, you will receive a pro-rata payment known as the "accrued interest". Conversely, if you buy a bond part way through its coupon period, you will have to compensate the previous holder. This way, the "clean" trade price of the bond is kept separate from the gradual roll-up of interest.

  • What is the income tax position on bonds?

    Income from bonds is paid gross, but is taxable and thus should be recorded on your tax return. If you hold bonds in a ISA or a SIPP, you will benefit from tax free income.

    Remember tax rules can change and the reliefs depend on your personal circumstances.

  • What is the capital gains tax position on bonds?

    Profit on Gilts is free from capital gains tax (CGT). The majority of Sterling bonds are free from capital gains tax, providing that they are "Qualifying Corporate Bonds". Broadly speaking this means most bonds apart from convertibles; however it is best to check if any individual issue is disqualified from this. Note, caution should also be used with low or zero coupon bonds, where the capital gain may be viewed as income.

    Remember tax rules can change and the reliefs depend on your personal circumstances.

  • What does subordinated mean?

    A subordinated bond is an issue which carries less seniority in the "pecking order" of the company's balance sheet. When times are good, this will make little difference, but in the event of the issuer hitting hard times, the coupon payment on certain classes of subordinated debt may be waived (see below). Also, if the issuing company is forced into liquidation, subordinated debt holders will only be paid out once senior debt has been repaid (note: subordinated debt holders will, however, rank ahead of equity holders). The ranking is as follows (with guidelines of typical features):

    • Senior Debt: this is the best
    • Lower Tier 2: No coupon deferral. The next best after senior debt.
    • Upper Tier 2: Coupon deferral, but cumulative.
    • Tier 1: Coupon deferral, non cumulative.
    • Preference Share. Generally, coupon payment can be waived, non-cumulative.
  • Where can I find out the full details of a bond so that I can check its level of security, such as priority ranking, restrictions etc?

    The full details of a bond are available in the prospectus. These documents can normally be obtained from the Investor Relations department (and often the website) of the issuing company.