Bonds: what are they and how do they work?

James McManus


3 min read

Bonds and bond markets are an important and often core part of a well-diversified investment portfolio. If you’re baffled by bonds here’s what they’re all about, in a nutshell.

Photo of bond notes
 
Bonds are just a type of investment. With a bond you are in effect lending a company – or government – the value of the bond (the nominal value), which it promises to repay at a later date (the maturity date), plus a fixed payment of interest, known as a coupon.

Depending on the terms of the bond, the coupon can be paid quarterly, semi-annually or annually.

How do bonds work?

Now, here’s the tricky bit – understanding bond prices and yields. The yield is a theoretical compound rate you would earn if every interest payment was re-invested back in the bond at current prices.

It works in reverse to the bond price which can rise or fall over the life of a bond, however the initial value will always be repaid at maturity. For example, most bonds are issued at a price of £100, and while this price can rise or fall over the bond’s life, when the bond matures (or expires) the company will be required to return £100 to the lender.

Falling prices can be good for prospective buyers as it means the yield is higher, but are bad news for bond holders as although their yield has increased, they have lost money on the price of the bond. Conversely rising prices are good for bond holders, who are then able to sell at an inflated price.

For example, let’s assume a bond is issued at £100, with a yield of 5%. If the bond price fell to £95, the yield will rise to 5.25%, making it more attractive to investors but leaving existing investors with a loss if they wanted to sell now.

Conversely, if the price of the bond were to rise to £105, the yield would now be 4.76%, meaning the bond is less attractive to new investors but existing investors may want to sell the bond to profit on the rise in price.

Yields and prices can rise or fall for many reasons, including the attractiveness of the borrower (the demand for the bonds), the risk appetite of investors, and the level of interest rates in the underlying economy.

Are they safe?

Bonds are typically considered to be one of the safest asset classes to hold within a portfolio, because they pay a fixed rate of return. However, the way bonds are priced and borrowers’ characteristics means that there are varying levels of risk.

Government bonds issued from stable economies, such as the UK or US, are considered to be very low risk, and therefore offer a much lower rate of return.

High-yield bonds, also known as ‘junk’ bonds, are generally issued by companies (or countries) with a less than perfect history of making repayments. With these bonds, investors could look to take on a higher level of risk with a view to potentially earning a higher rate of return.

How are bonds performing?

So far in 2017, bond market performance has been mixed. US government bonds have been rising, while the performance of UK and German government bonds has been slightly negative overall. Corporate bonds meanwhile have generally performed well across developed markets.

Here at Nutmeg, we’ve been cautious on government bonds for some time now, judging the government bond market to be vulnerable to interest rates increases and the removal of fiscal stimulus.

The US Federal Reserve has been slowly raising interest rates (rising interest rates result in higher yields for government bonds, meaning the price of a bond decreases), and the market could be further impacted by the unwinding of quantitative easing programmes, as there will be less demand for these bonds.

We’ve actively reduced the interest rate sensitivity of our portfolios and are currently holding fewer bonds than you may typically expect of us. However, we still believe bonds have a place in portfolios as a lower volatility, diversifying asset.

Risk warning: As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.

 

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James McManus

A self-confessed ETF geek, James is head of ETF research at Nutmeg. He joined in 2015 from Coutts & Co, where he was an associate director in the investment office. James holds a Bsc (Hons) in International Business from Nottingham Business School.


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