Governments and companies raise funds by selling or ‘issuing’ bonds to investors.
How do bonds work?
Bonds have traditionally been a safe haven for investors thanks to lower risk and volatility than equities and alternatives. After the mini budget in September 2022, however, bonds were hit hard, leaving many questioning their role as a diversifier.
Despite the knockback of last year, there is no doubt that bonds do play an important role in portfolio management. In this short article, we look at why, by going over what a bond is, how a bond works and how they can be used to help achieve an investor’s financial aims.
What is a bond?
Governments and companies raise funds by selling or ‘issuing’ bonds to investors. At issuance, bonds are sold with a specified interest rate and a term length. Investors receive regular payments (or coupons) for that agreed term, with payments calculated according to its rate. At the end of the bond’s term, the bond ‘matures’, which is when the issuer has to pay back the bond’s initial amount to the investor.
In general, bonds that are deemed higher quality offer lower interest rates. The quality is determined by the likelihood of default. The more likely a government or company is to repay the bond, as well as the interest, the better the quality. When a bond has a shorter time to maturity, they usually offer a lower interest rate too.
An important differentiation between stocks and bonds is that bonds don’t give any ownership rights to investors.
How do bonds work?
Investors buy bonds as they can help make returns in portfolios in two ways:
- Interest payments: While interest payments are to recompense investors for loaning a company money, they also offer a financial gain and a useful income stream.
- Price fluctuations: Bond prices go up and down after issuance, so it’s possible to buy and then sell bonds for a profit. Price fluctuations occur for a variety of reasons. It could be that during a bond’s lifespan, the issuer’s credit risk profile improves. Any issued bonds consequently rise in price thanks to being deemed more creditworthy. Or, if newer bonds are sold with a lower interest rate, an older bond with a higher rate will see its price increase.
The latter point creates a vital idea in the fixed income world: bond prices and interest rates have an inverse relationship. So, if interest rates rise across the markets in general, bond prices typically fall.
So why use bonds?
Despite the ‘annus horribilis’ for bonds that was 2022, they can still play a key role in portfolios as a diversifier and protecting against risk. They’re usually safer investments than equities as bonds (should) repay the initial investment. Stocks do not come with such a promise.
The reason that bonds provided little security in 2022 was due to inflation. High inflation erodes away the value in real terms of both coupons and the final capital repayment. So when the stock markets tumbled in 2022, the high inflationary environment meant that bonds could do little in the form of protection.
Despite that, bonds are currently becoming more attractive than they have been for years. Inflation fears are starting to calm, so it’s more likely that investors will start seeking out the safety of bonds again, increasing demand. In addition, corporate bonds in both the UK and abroad are looking more interesting too, as higher yields and better credit spreads (the extra interest amount paid by companies compared to government bonds) has widened.
The improving environment for bonds means that a fixed income allocation within portfolio can not only offer protection in portfolios, but returns too. While those returns may not potentially be as lofty as equities, bonds are still vital when constructing a portfolio to meet client objectives.
The Investment Management Team, Square Mile Investment Services
23 March 2023
Park Hall Financial Services Limited is authorised and regulated by the Financial Conduct Authority.
The information within this article is for information purposes only and does not constitute investment advice. They represent the opinions of the fund manager and those of Square Mile. It does not contain all of the information which as an investor may require in order to make an investment decision. Any reference to shares/investments is not a recommendation to buy or sell. If you are unsure, you should seek professional independent financial advice.
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