Debt securities like bonds and gilts (government bonds) can offer the attraction of greater security than stocks and shares alongside regular income and can be a good option as part of a balanced portfolio.
While debt securities may offer a predictable income stream, the minimum trade size for many of the bonds issued by companies can be upwards of £10,000.
Buying an exchange-traded fund (ETF) which offers exposure to a selected basket of bonds or gilts is perhaps the best route for a newcomer to this market to pursue.
By purchasing a debt security, you are essentially lending money to a company, in the case of a corporate bond, or government, in the case of gilts, which will be repaid after a fixed-term (when it is said to have matured), and at a fixed rate of interest.
So, where a shareholder is a part-owner of a company, a bondholder is a creditor. Should a company be declared insolvent then bondholders are typically paid out along with other creditors. In this case, a shareholder is last in the queue and often ends up with nothing.
Interest on a debt security is paid out as a regular ‘coupon’. The dividend paid by a company to its shareholders can be cancelled entirely at its own discretion but if the issuer of a debt security skipped a coupon payment it would be in default and the value of the bonds would go through the floor.
The only element of a bond which is not fixed is the price and bonds can be bought and sold ahead of their maturity.
RISK VERSUS RETURN
The security offered by bonds makes them lower risk than shares. On the basis that risk should be proportionate to the level of return, you would expect equities to offer more significant gains.
It is worth noting that rising interest rates can cause bond prices to decline and falling interest rates can result in bond prices moving up.
A key risk to bear in mind when investing in any debt security is inflation; in an inflationary environment the fixed interest offered by bonds becomes less valuable and people rush to sell them, further depreciating their value. Inflation also tends to prompt an increase in interest rates.
Some ETFs offer exposure to bonds which track inflation - the iShares Index Linked Gilts ETF (INXG) being a good example.
The most important features of a debt security are the issuer, the maturity and the coupon. In addition to companies, governments, government agencies and supra-national bodies such as the European Investment Bank can issue bonds.
MAKING THE GRADE
There is a clear pecking order in bond quality - reflecting the likelihood of getting your money back.
Government bonds have traditionally been the most secure and as such are used to benchmark the bond market. They are by far the biggest issuers and if they borrow in their own currency they should always, in theory at least, be able to print more cash to pay the coupon.
A rough guide to credit quality is provided by ratings agencies such as Standard and Poor’s (S&P), Moody’s and Fitch.
S&P and Fitch both grade bonds in descending order from AAA to AA+, AA, AA-, BBB+ and so on. Bonds rated at BBB- or above are known as investment grade.
Any downgrade in rating will lower a bond's price and if a security slips below investment grade the price could collapse as the number of institutional investors sanctioned to buy non-investment grade or ‘junk’ bonds is extremely limited.
The longer the period to maturity, the greater the return on the bond. This is compensation for the risk posed by the longer holding period.
For example, UK gilts which pay out after just a month offered a yield of 0.274% at the time of writing while those with a 20-year term offered a yield of 1.8%. Price volatility also tends to be higher on longer-dated bonds.
