Bonds have been around for a long time but it is only recently that they have begun to be more widely accessible to and popular with private investors in a greater variety of forms. Older generations of investors may have bought government bonds, or gilts, as an alternative to putting cash into a savings account but likely have been largely unaware of corporate bonds, let alone inclined, or able, to invest in them. Gilts are a low-risk (at least those issued by countries like the UK), relatively low return investment. But there are now a wide variety of different kinds of bonds offer a similar variety of risk and return levels. The main bond categories are explained below.
What is a bond?
Bonds are essentially debt-issuances offered by governments, companies and other organisations. They are often compared to IOUs. When a company wishes to raise finance it can do so either by selling equity in the company, issuing shares, or by selling debt, issuing bonds. Governments and other organisations which can’t offer ownership stakes are restricted to bonds. Generally speaking, bonds have a very simple structure. You have the bond’s issuer, which is borrowing money. The bond’s coupon is the interest on the loan that the borrower agrees to pay and the maturity or redemption date is when the borrower returns the loan. Interest payments are made either annually, bi-annually or quarterly depending on the conditions of the bond.
Kinds of Bonds
These are issued by governments to fund public spending. When you hear about a country’s ‘national debt’ this is in large part made up of the unredeemed bonds it has in circulation; held by banks, financial institutions, other countries and private investors. Government gilts can be traded on exchanges with their value fluctuating up and down with interest rates and the country’s credit rating as assigned by the major ratings agencies. Interest rates offered on gilts are higher or lower depending on the perceived stability of the country’s finances. Countries such as the UK, the USA and Germany will offer very low interest rates on gilts issued as the risk of default is considered to be minimal. Countries experiencing economic troubles, Greece being a recent example, will have to offer far higher returns to entice investors to lend to them through buying their bonds.
Government bonds can offer fixed interest rates or variable rates linked to a defined index (such as the UK Retail Prices Index). They can also be fixed term meaning that the value of the bond is returned to the bond holder at a pre-defined date, or undated, meaning the government may or may not buy the debt back at a time of their choosing.
Retail bonds are offered by companies and are intended for retail investors. They can generally be bought in relatively small increments, of £1000, or less in some cases. These bonds are listed on an exchange, the London Stock Exchange’s Order Book for Retail Bonds (ORB) in the UK, and can be freely bought or sold before their maturity date. While the buy-back price will be the same as that of the initial purchase price, exchange-traded values will fluctuate to some extent based on interest rate expectations and the perceived risk of the issuer defaulting.
Mini Bonds/Corporate Bonds
Like retail bonds, corporate or mini bonds as they are now often referred to are also issued by companies. The primary difference to retail bonds is that these bonds are not listed on an exchange and so their value cannot be redeemed before their redemption date, though they do often provide the option of earlier redemption at set junctures throughout their lifetime. There is often some level of penalty, commonly between 5% and 10%, if the holder chooses to redeem the bond earlier in its intended lifetime. However, conditions attached to the issuance of mini bonds can vary greatly. Mini bonds are becoming an increasingly popular way for SMEs to raise finance. As with all bonds the risk to the investor is in the issuer of the bond defaulting due to insolvency or being able to meet interest payments as a result of cash flow difficulties.
As corporate bonds are issued by such a wide variety of companies, investors must carefully assess the chances of the issuer being unable to meet the bond’s terms. As such this kind of bond is only open to sophisticated and high net worth investors who are presumed to be able to make a calculated risk assessment.