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.
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.
- Types of
- 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.
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.
Why choose bonds?
Risk of default
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.
Frequently asked questions
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 issuer's 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:
|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.|
|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.
Ratings AAA through to BBB 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'.
Frequently asked questions
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. 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.
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".
|British Telecommunication PLC||8.625%||26 Mar 2020||6yrs 10mths||137.47||2.565%|
Simply select one of the terms below to read the definition:
Frequently Asked Questions
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.