The concept of a bond is simple. It is a loan that an investor makes to either a government (GILT) or a company (Corporate bond) in order to help the respective parties raise funds. The benefit for the investor is that the issuer of the bond agrees to pay you a FIXED level of return for a number of years depending on the type of the bond. Corporate bonds are typically popular as part of a diversified portfolio because they provide an element of caution. They provide a less risky option than exposure to the volatile equity markets.
In addition to the fixed level or return or ‘fixed income’, the issuer of a bond also makes a promise to repay the full amount of your original loan at an agreed date. The date will be sometime in the future, and is known as the ‘maturity’ of the bond.
A corporate bond is usually given a rating depending how analysts perceive their ability to fully repay the debt. The bonds with the highest chance of full repayment are called ‘investment grade’, while those with a less outlook are known as ‘high yield’ or ‘junk bonds’. Investing in ‘junk bonds’ are high risk in comparison to ‘investment grade’ bonds because there is a far stronger chancer that you will never get all your money back. Bonds are rated on a letter scale, those with a scale ranging from AAA-BBB are generally classed as less risky bonds. However those falling below this range up to a D scale offer far more risk as there is a higher chance of the bond issuer defaulting on their repayments.
Bonds can freely be traded like shares, and some investors opt to sell them before their maturity date. This is because bonds can be in high demand depending on long term interest rates. For example, if a bond pays a fixed return of 8% and interest rates fall from 3% to 2%, then the bond will start to look more attractive. However, if interest rates rise to 4%, then the value of the bond suddenly looks less appealing and this will be reflected in a fall in trading price.
It is possible to invest in bonds through a stockbroker or through a corporate bond fund. Clearly, the latter offers you the opportunity to take advantage of a ‘fund managers’ expertise.
Further details on GILTs can be found here.