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How to invest in bonds – what are they and why do they matter?

As everyone’s eyes are fixed on interest rates, we look at bonds and why they’re important.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

When we think of investments, we often leap straight to the headline-grabbing shares. But more money is invested in bonds every year than shares – in fact there’s well over $100tn invested in bonds worldwide. And more recently, bonds have been taking centre stage.

You can’t escape talk about interest rates or inflation right now. And when interest rates are high, bonds can be a useful gadget in an investor’s toolkit.

But what are bonds, why do they matter and how can investors use them?

This article isn’t personal advice. If you’re not sure whether an investment is right for you, ask for financial advice. All investments and any income from them can fall as well as rise in value, so you could get back less than you invest. Income from bonds is not guaranteed and yields are variable.

What is a bond?

There are lots of things that have the word bond in the title. To be clear though, we’re not talking about premium bonds, fixed-rate savings bonds or Bond Street in Monopoly. They do all involve money, but they’re not what we’re focusing on.

We’re talking about bonds traded between investors.

Bonds are where an investor loans money to either a government or a company. In return, they promise the full amount back on a specific date, with a set amount of regular interest on top – effectively an IOU.

If you were to hold the bond until it matures, you’d receive the amount that was originally loaned, plus the interest over the period it was held.

But they can also be bought and sold by investors over the lifetime of the bond.

There are two main types, government bonds and corporate bonds.

Government bonds

Government bonds are issued by governments all around the world – in the UK, they’re known as gilts. Governments use the money for various initiatives, like investing in infrastructure or making sure there’s enough money for its day-to-day spending.

Government bonds are often the ‘safest’ form of bond. This is because a government often has control of its currency, so can print more money to pay back investors if it needs to.

But because of this, government bonds don’t often offer the highest interest rates.

Corporate bonds

These are issued by companies from around the world. They might use them to fund projects or liabilities the company has.

As a company can’t print money to repay the debt if they need to, they often offer higher interest rates for the higher levels of risk.

How do bonds work?

Pricing and income

Bonds are normally issued at a price of 100p per unit, which is known as the par value.

Most bonds pay interest – this is given as a percentage of that 100p, which is known as a coupon. This is the amount of income you get each year.

If you bought one unit of a bond when issued at 100p per unit, that paid a coupon of 5%, you’d get 5p every year.

As bonds are traded, they can be bought and sold below or above the price at which they were issued at. The amount of income based on what you pay is known as the yield. There are lots of ways to calculate yield, but the most simple way is the rate of income as a percentage of the current price.

Perception of whether the bond or interest can be repaid can move the price, but it also depends on the interest rates central banks set.

When the base interest rate rises, the price of bonds tends to fall. That’s because the interest on offer won’t now look as attractive as when rates were lower.

So, if the base rate the Bank of England sets is higher than current yields on bonds, bond prices will generally fall – why pay more money for a lower rate of income?

If higher interest rates cause bond prices to fall, that also means the yield increases – what you get as a percentage of the price you paid.

Default risk

The risk that a bond can’t pay back its debt is known as its default risk. Companies like Moody’s and Standard & Poor’s calculate this risk and give each bond a credit rating.

Corporate bonds with a high credit rating are said to be ‘investment grade’ as they have a low chance of not repaying their debt. Those with a lower credit rating can be called high-yield bonds, because they have to offer a higher rate of interest to compensate investors for the added risk.

Why bonds matter

They can provide a reliable income – this can be valuable for those looking to take money from their investments without having to sell them. This might be useful in retirement, for school fees or as an alternative income. On an individual bond, you know what the income is and how often you’ll receive it.

They’re often more stable than shares – the price of a bond isn’t decided by whether the company looks to generate lots of profit, just that they can repay the loan and the interest. Usually, bonds have to be repaid before shareholders, so they can often be less volatile.

Bonds offer something different to shares. They are a great way to diversify an existing portfolio, which should hold a mixture of different types of investments.

Find out more about diversification

Want to invest in bonds?

If you’re looking to invest in bonds, funds can be a great way to do it.

Lots of bonds need very high initial values to buy them and aren’t generally available to individual investors.

A fund can give not only the expertise of the manager, but also access to a wider universe of government and corporate bonds.

You can start investing in a fund from £25 a month as a direct debit or £100 as a lump sum.

HL Global Corporate Bond Fund

We’re launching a new fund managed by our experts and investing in corporate bonds from around the world. Invest before 11:59pm, 19 July to get the fixed launch price of £1 per unit.

Discover the HL Global Corporate Bond Fund

The HL Global Corporate Bond Fund is managed by our sister company Hargreaves Lansdown Fund Managers Ltd.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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