A bond is an interest-bearing IOU. An investor lends cash to a government or company, which agrees to give it back on a certain date. Until the debt is repaid the investor receives a percentage of the investment each year as interest, known as the coupon.
A fixed-income investment can be an important part of building a balanced portfolio to hedge against volatile equities. Bonds are not a get-rich-quick product; they are a wealth protection tool that generates a regular income.
Companies and governments have been issuing bonds for hundreds of years to drive growth, balance their budgets and fund wars, but the retail market is a new phenomenon in the UK thanks to 2007’s financial crisis. Firms could not access bank debt. Investors wanted secure income at a time when record-low interest rates introduced by central banks to fight the crisis deprived them of it.
To facilitate this meeting of minds, and wallets, the London Stock Exchange (LSE) launched the Order Book for Retail Bonds (ORB). This new platform allows you to buy bonds in smaller denominations, such as £1,000, instead of the £100,000 minimum needed to purchase a corporate bond or Government Gilt.
Yield to me
Bonds can be used to provide ballast to a portfolio and keep the cash trickling in, even if other asset classes such as commodities or equities are proving volatile. The key now is how to go about choosing the right bond for you and one of the most important valuation metrics when buying a bond is yield - the rate of interest paid to an investor.
Daren Ruane, senior bond strategist at Investec Wealth & Investment, says investors can now buy yield in a low interest rate market. ‘Equities have done very well and some have high dividend yields, but if you want to buy something less volatile and safer, bonds are a way to do it.’
When you buy a bond at par, its yield is equal to the interest rate. When the price changes, so does the yield. If, for example, you buy a bond with a £100 par value and a 10% coupon its yield is 10%. But if the price falls to £80, its yield rises to 12.5% because if held to maturity the investor will receive £100 for an £80 asset. If the price rises to £120, the yield falls to 8.3%.
So when the price goes up, yield falls and vice versa. A bond’s price and its yield are inversely related.
Another metric is yield to maturity. This shows all the coupon payments and any capital gains made if bought at a discount or a premium if the bond is held until maturity.
Make the grade
There has not been a default on the ORB in the first four years, but this does not mean retail bonds are risk free. Bonds are not covered by the Financial Services Compensation Scheme (FSCS) so you stand to lose your cash if the issuer cannot pay its debt and ends up in administration.
Debt comes in many classes. They determine where an investor stands in the queue to get their cash back if the issuer does go bust.
• Secured debt is the highest quality a company can issue. If it defaults its assets are sold to repay the debt. This usually means the investor receives lower interest payments to reflect the lower risk of losing their cash.
• Unsecured debt is riskier. You may get some or all of your cash back if there is enough left after the issuer has been liquidated. In the unsecured world, those holding senior debt stand ahead of subordinated or junior debt in the queue to get their cash back. Unsecured debt should come with a higher coupon to compensate for the higher risk.
Take the credit
One way of assessing an issuer’s security is to look at its credit rating, which is the opinion of an independent company on the probability of a default. So the higher the credit rating the safer your cash is deemed to be.
The highest rating is AAA, followed by AA, A and BBB. All these ratings are classed as investment grade. BB down to D are classed as sub-investment grade, also known as high yield debt or junk. The benefit of a credit rating for an issuer is that the higher the rating the lower its borrowing costs will be.
There are several rating agencies, but the three main companies are Fitch, Standard & Poor’s and Moody’s.
When handing your hard-earned cash to a company or government you have to ensure that the risk of making the investment reflects the reward (coupon payments) you will receive. The lower an issuer’s credit rating, the higher the risk of default and so the coupon payments should be high to reflect this risk. There are, however, three main risks bond investors are exposed to.
• Credit risk. If the issuer or guarantor runs into trouble, or worse, insolvency, investors could lose some or all of their investment.
• Market risk. Interest rate changes alter the value of the investment and the price it can be bought or sold at.
• Liquidity risk. Market conditions will affect the bid/offer spread of the bond. You may not find anyone to buy it from you if you need your money back.
One of the benefits retail bonds offer is that investors are not stuck with the investment until it matures, which can take from between five to 10 years in this market. An investor can get their cash out earlier if needed through selling it in the secondary market. This also provides investors with the opportunity to make money from the market, if the bond is trading below par (the price it will be redeemed at when it matures). If a bond, for example, is trading at £80 and has a par value of £100, an investor buying that paper will collect £20 more than they invested if held to maturity, along with the coupon payments.
The rule of thumb is, those looking to buy bonds in the secondary market should look for high yields, while those looking to exit should sell when yields are low or they will lose cash.
There are several factors driving price movements in the bond market. These include changes to the issuer’s creditworthiness as well as macro-economic factors such as interest rate movements. If the base rate rises investors could dump bonds to move their cash into saving accounts, which are less risky as up to £85,000 is guaranteed by the FSCS.
From 1 July, all retail bonds can now be held in the New Individual Savings Account (Nisa). In this year’s Budget the Government abolished a ruling forbidding bonds with less than five years to maturity from being held in a tax wrapper.
Retail bond investor checklist
Decide how much you want to invest, over what period and how much you want to make?
Is the risk worth the reward?
Are you looking at the right asset class? How do the coupons on offer compare to interest rates on savings accounts?
Is the issuer capable of generating the revenue needed to repay the debt?
How secure is the investment?
How accurate is the credit rating?
Should you buy the debt or the equity? How does the coupon compare to the dividend its equity owners receive?
Is the bond liquid?