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.
- What are
- Credit rating
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 are bonds 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.
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.
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.
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).
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.
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.