Bonds

To an investor just starting out, bonds can be more than a little intimidating.

First, there are many different types of bonds – you’ve got corporate bonds, retail bonds, government bonds or ‘gilts’ and index-linked bonds to name but a few.

And then there’s the jargon – what on earth is a coupon when it’s at home?

Here, in the first of a series of articles on bonds, we explain exactly what bonds are and dejargonify some of the terms associated with them.
What is a bond?

A bond is essentially an IOU.

You lend your money to a company or the government – depending what type of bond you invest in – on the understanding that they will pay you back in full on a set date plus interest.

As you know exactly what rate of interest you will earn and when you will get your initial investment back they can be an exceptionally useful financial planning tool.

Our example

Now for a guide to some basic bond terminology.

Take a fictional company: ‘Bonds R Us’.

Bonds R Us has decided to raise capital by issuing a 10-year sterling bond with a fixed annual coupon of 5%. The bond requires an initial minimum investment of £1,000 and is available in denominations of £100 thereafter. The offer period is between 1 August 2012 and 14 August 2012.

Interest

Let’s start with the word ‘coupon’.

Coupon is simply a fancy word for the interest rate – it dates back to the days when bond owners were issued a certificate with coupons attached which they would then rip off and hand over when it was time to claim their interest payments.

The annual interest rate or ‘coupon’ is expressed as a fixed percentage of the value of the bond.

So if, for example, you buy a £1,000 bond which has a coupon of 5% like above, this means you will net £50 in interest each year – though this is usually split into two six-monthly payments of £25.

The word fixed simply means that the interest rate offered by Bonds R Us is guaranteed to stay the same for the duration of the bond term – which in this case is 10 years – regardless of what happens to interest rates, inflation and the wider economy.

‘Sterling’, meanwhile, just specifies you are investing in pounds and will earn interest paid in pounds, as opposed to a dollar bond, for example.

Offer period

The issue date is when the bond is made available to investors, and the offer period states how long investors have to ponder their purchase – though companies retain the right to close their bond earlier if they raise the money they need quicker than expected.

On the other hand, should they not raise enough or decide they need more you might see a second issue of the same bond announced at a later date.

Once the bond’s offer period is closed you will only be able to invest via the London Stock Exchange, but more on that later.

Maturity date

This is when you are due to get your initial investment back – you might also hear it referred to as ‘redemption date’.

Your maturity date will depend on the term of the bond you invest in. In the case of the Bonds R Us 10-year bond above, the maturity date will be in August 2022 – 10 years on from when the bond is issued.
Your investment

Most bonds demand a minimum initial investment. For corporate bonds this could be as much as £50,000, while retail bonds which are aimed at the wider public may ask for just £1,000.

Once you have purchased the minimum initial amount of bonds, you are usually allowed to invest in smaller sums of say £100, like in the Bonds R Us example above.

The amount you invest, and which is therefore returned to you if you hold the bond to maturity, is known as the ‘par’, ‘principle, or ‘face’ value of the bond.

The term is particularly important should you decide to later trade your bond, or buy a bond, on the secondary market.

Par

As I mentioned earlier, you can buy and sell bonds on the London Stock exchange – which is useful for people who decide they do not want to hold their bond until maturity.

However, investors need to be aware that bond prices on the London Stock Exchange fluctuate according to market conditions.

If your bond is trading for more than you initially paid for it – say £1,200 for every £1,000 you invested – it is said to be trading ‘above par’. If it’s trading for less – ie £800 for every £1,000 invested – it is trading ‘below par’.

The price you get for your bond depends on how much appetite there is for the interest rate it pays.

Take the Bonds R Us bond paying 5%, for example. If interest rates rise over the next few years, you will likely find the value of your bond decreases on the secondary market as more competitive deals become available. If interest rates fall, however, you should find your bond is worth more.

Yield

If you buy a bond second hand you will hear the word ‘yield’ a lot. It simply means the rate of return you get on the bond.

If you buy a bond at par – ie you pay the bond’s face value – the yield is equal to the bond’s coupon or interest rate. So in the Bonds R Us example, your yield will be 5%.

However, if you buy a bond at a discount your yield will be higher than the original coupon rate, while if you pay more it will be lower.

This is because regardless of whether you pay £800 or £1,200 for a £1,000 bond, you are still earning an annual coupon of £50. So rather than earning a 5% rate, you are actually earning 6.25% if you pay £800, and roughly 4.17% if you pay £1,200.

The calculation for this ‘current yield’ – or ‘running yield’ as you might also hear it called – is the annual interest paid divided by the price you pay for the bond times 100.

There is also something called ‘yield to maturity’ or ‘redemption yield’, which is the return you will earn if you hold the bond for the full term, including all the interest payments as well as any profit or loss you will make when you get the initial investment back at the end of the term.

Risk

The final thing we’re going touch on in this article is risk. When you invest in a bond you are investing in the future of a company or if you buy gilts, the government.

Unlike when you invest in a savings account with the Financial Services Compensation Scheme (FSCS) to fall back on should the company fall into difficulties, there is no such safety net when you invest in bonds. It is therefore important that you take the time to research the company before investing to ensure the company is likely to pay what it promises.

There are a number of credit rating agencies – Moody’s, Standard and Poor’s and Fitch being the big three – which ‘rate’ a company’s bonds according to the risk they believe them to pose.

AAA is the highest investment grade awarded, while anything lower than a BBB- is considered non-investment grade or ‘junk’. Junk bonds usually promise investors higher returns in order to compensate them for taking a greater risk – these are often referred to as ‘high yield bonds’.

Definition of ‘Treasury Bill – T-Bill’