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What is a bond, and why would you hold one?
A bond is a loan. You lend money to a government or a company, they pay you interest for a fixed period, and they aim to give your money back at the end. That is the whole idea. Everything else is detail.
What is it?
A loan to a government or a company, with interest paid at set intervals and the capital repaid at the end. Repayment is not guaranteed.
Why hold one?
For a predictable income and, historically, less price movement than shares. Many people use bonds to spread risk across a portfolio.
What is the catch?
The value can still fall. Interest rates, the health of the borrower, and how long the loan runs all move the price.
A worked example
Say you lend £1,000 for 5 years at 5%. Those three numbers are picked to keep the sums easy. Everything below follows from them.
+£50
+£50
+£50
+£50
+£1,000
+£50
−£1,000
Day one
Year 1
Year 2
Year 3
Year 4
Year 5
Money out. You lend it. The money leaves your account and goes to the borrower.
Money in. They pay you interest. £50 once a year, at the rate agreed on day one, so you know the amount in advance.
Money in. You get your money back. If the borrower pays. That is the risk you are taking.
- Day one−£1,000
You lend it
The money leaves your account and goes to the borrower.
- Years 1 to 5+£50 a year
They pay you interest
£50 once a year, at the rate agreed on day one, so you know the amount in advance.
- End of year 5+£1,000
You get your money back
If the borrower pays. That is the risk you are taking.
You lent £1,000 and, if it all goes to plan, you get £1,250 back. £250 of that is the interest, £50 a year for 5 years. That is the whole idea of a bond.
An example, not an offer. £1,000 at 5% for 5 years is chosen to make the arithmetic easy to follow. Real rates differ from bond to bond and move over time, and this takes no account of charges or tax. It assumes you hold the bond to the end: sell earlier and you get whatever it is worth that day, which may be more or less than you paid. Above all, the repayment is an aim rather than a promise. If the borrower fails you will get back less than you lent, and that risk is exactly why one borrower has to offer more interest than another. It is also why a fund manager holds hundreds of bonds within a fund rather than a few.
Types of bond
Not all bonds are the same thing
The word covers a wide range, from lending to a government to lending to a company that has to pay higher rates. The differences matter more than the word does.
- 01
Government bonds
Called gilts in the UK
Governments issue bonds to pay for public spending: healthcare, education, roads and railways. In the UK they are called gilts. They are generally regarded as one of the lower-risk areas of the bond market, because a developed economy usually has a strong ability to meet its debts.
- 02
Investment grade corporate bonds
Large, established companies
Big companies borrow by issuing bonds too, BP among them. Firms with stronger balance sheets and higher independent credit ratings do not have to offer as much interest to attract lenders, because lending to them is seen as less likely to go wrong.
- 03
High yield bonds
Also called non-investment grade
Some companies have to offer more interest to attract investors, because lending to them carries more risk. Marks and Spencer is an example. They may offer higher income, and they also carry a higher chance that the loan is not repaid.
The bond ladder
Lower risk at the top. Every rung down pays more interest, but the risk of not getting the capital back increases. Sensitivity to interest rate changes rises with duration, and duration shortens as the risk of the borrower failing rises, which balances the volatility out.
Investment grade
Lending to large, financially established companies with strong independent credit ratings.
- Yield it pays
- 3% to 6%
- Duration
- 1 to 15 years
- Fall in a bad year
- 6% to 25%
- You are lending to
- Companies of the size of a major bank, or a utility
The trade-off. A little more income than a government pays, because a company is a little less certain to pay back the loan than a government. Most of the extra is compensation for that, not a free lunch.
Generally suits money you can leave for three to five years, to diversify the volatility in a portfolio
Two different scales: yield runs 0 to 10%, duration runs 0 to 25 years.
Yield is not return. Indicative ranges for each part of the bond market, not figures for any particular fund, and not forecasts. A yield is the income paid at today’s price; your return would also depend on what happens to that price, on charges, and on whether every borrower repays. Past performance is not a guide to future returns and you may get back less than you invest. This is information, not advice, and takes no account of your circumstances.
Active management
Somebody has to decide which loans are worth making
A bond fund can hold hundreds of separate loans. Some managers simply track an index. Others are tactical: they research individual companies alongside the wider economy, and move the fund between different parts of the market as conditions change, including into money market investments when they judge it right.
That is the argument for active management in high yield and strategic bond sectors in particular, where the difference between a borrower that repays and one that does not is a matter of research rather than of index weighting.
It is also why charges differ between funds, and why the research you do before buying matters more here than almost anywhere else.
Where bond funds can be held
In the same accounts you already know
- Stocks & Shares ISANo UK tax on returns inside the wrapper. Up to £20,000 a year.
- General Investment AccountNo annual limit, and no ISA tax treatment either.
Those are the two accounts most people use for a lump sum. Different platforms give access to different investments, services and charging structures. Our where to invest section explains the account types and lists UK platforms authorised by the FCA.
Information, not advice. This page explains how bonds work in general terms. It is not personal advice, not a recommendation, and takes no account of your circumstances. The value of investments and any income received from them can fall as well as rise, and investors may receive back less than they originally invested. Past performance is not a guide to future returns. This information is made available solely to persons who are resident in the United Kingdom.
Go deeper
The rest of it, in detail
Three reference pages for when you want more than the summary: what the words mean, what sits inside each part of the market, and what the named risks in a fund document actually are.