What Are Bonds & How Do They Work?

Please note that the value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.

Bonds have traditionally been a safe option for investors due 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 this, there is no doubt that bonds still play an important role in portfolio management. Below, we will look at why, by going over what a bond is, how one 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. When issued, 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 must 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 do not give any ownership rights to investors.

How do bonds work?

Investors buy bonds as they can help make returns in portfolios in two ways:

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 a tough year in 2022, bonds can still play a key role in portfolios as a diversifier and protect 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 a 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 an investor’s objectives.