Page 24 - DIY Investor Magazine Issue 24
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Unlike a share, where investors literally buy a share in a company’s profits, a bond is an ‘IOU’ from a company to an investor who loans it money; Christian Leeming considers why DIY investors may wish to hold them in their portfolio.
Bonds guarantee to pay a fixed rate of interest over a fixed period; the rate of interest and duration of the loan is set when the bond is issued, which is why bonds are sometimes known as ‘fixed interest’ investments, or ‘debt securities’.
Interest is paid via a series of annual or semi-annual ‘coupons’, and once the bond reaches its expiry
date - ‘maturity’ - the issuer is obliged to pay back the bondholder their initial investment in full.
Bonds originally had detachable, individually-numbered coupons which investors would send to the issuer to claim their payment, hence the term; today, interest payments are made electronically into your account.
A bond is form of investment which usually offers little potential for capital growth, but delivers regular income to the investor while he or she holds it.
Bonds can be issued by a corporation, a government or non-government organisations like the World Bank, to raise money.
The amount of income that bonds pay reflects the ‘risk premium’ attached to them; the riskier a company (or country) is, the higher the coupon its bonds will offer.
Very large and well established companies with solid earnings and high ‘ratings’ from agencies tend to pay a lower coupon – because the risk premium attached to owning their bonds is lower.
Government bonds, also known as ‘sovereign bonds’ or ‘gilts’ (those issued by the Bank of England), tend to pay lower coupons still – the theory being that countries are even less likely to collapse than corporations.
Gilts in the UK or ‘treasuries’ in the US, have traditionally been seen as the most secure and as such are used to benchmark the bond market; they are by far the biggest issuers and as long as they borrow in their own currency they should always be able to print more money to pay the coupon.
Ratings agencies such as Standard and Poor’s, Moody’s and Fitch provide a guide to credit quality – the likelihood of the investor being repaid – by grading bonds in descending order from AAA to AA+, AA, AA-, BBB+ etc. ‘Investment grade’ bonds are those rated BBB and above; investors can achieve higher rates of interest by buying ‘high yield’ or ‘junk bonds’ – but only if they avoid those companies that go bust.
Well-known international companies are seen as likely to pay bondholders back and their bonds typically have quite low interest rates; companies in a poor financial situation, or already saddled with a lot of debt, typically need to pay much higher interest rates to compensate investors for the additional risk of buying their bonds.
In February 2010 the London Stock Exchange (LSE) launched the Order Book for Retail Bonds (ORB) with the objective of making a new generation of retail bonds accessible to the retail investor and providing liquidity in the secondary market for those that did not wish to hold the investment to maturity.
Most bonds issued on ORB offered a relatively low minimum investment, typically £2,000, and with relatively generous rates of interest were in demand for those
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