Learn about bonds

Bonds are securities representing the debt of a government, company or other organisation. Effectively they are loan stock, or "IOUs" issued by these organisations and bought by investors such as banks, insurance companies and fund managers.

Investors are often heard to say "I don't understand bonds", but the truth is that these instruments 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 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 are then free to trade 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 market in bonds is enormous. The number of bonds in circulation is considerable, and a large and regular issuer such as the European Investment Bank may have several hundred issues 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.

Below is further information about the various types of bonds on this website.

Gilts or UK Government bonds

These are bonds issued by the UK Government in order to finance public spending. UK Gilts are rated AAA by all the major credit ratings agencies which is the highest credit rating available. The price of these investments 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.

Conventional Gilts

The majority of Gilts are of a conventional nature, paying a fixed coupon (generally twice a year) and maturing at a set date. The life of these instruments will vary from a few months to as much as 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

These were first issued in 1981. Rather than pay a fixed coupon and amount on redemption Index-linked Gilts differ from conventional Gilts in that the semi-annual coupon payments and the 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

These differ from conventional Gilts as they have no set maturity date. They may (or may not!) be paid back at a time of the government's choosing.

Because of this the holder is reliant on the market price to liquidate his investment, and as such they should be viewed as more risky than conventional Gilts.  The most well known amongst this group is the UK 3.5% War Loan.

These instruments are more volatile than conventional Gilts (which inevitably trend towards par).

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, ranging from foreign governments and their agencies, through to UK Banks and all the way down to medium-sized companies. As with Gilts, the prices of these bonds will move alongside the market's expectations for interest rates. However, the price (and thus the yield) will also be affected by the perception of the credit quality of the issuer. If this is thought to be deteriorating, the price of the bond will fall.

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. These are known as "equity convertibles" and 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 that the holder has a priority claim on the company's assets, ahead of that of the shareholders. Some bonds are issued with "subordinated" status. This means that the buyer of the bonds accepts a lower claim on the company's assets, below the senior debt holders, but above the equity holders. Because of the additional risk, a higher yield will be offered.