Why bonds can be attractive to investors
Bonds hold several attractions for investors. The first is that they can add stability to a portfolio. This is because of the relative certainty of the income streams they provide. ‘Hard currency’ bonds issued by advanced countries such as the US, for example, are normally seen as the safest bonds of all because of the relative security of the income. Companies must also prioritise paying their dues to their bond holders before giving any dividends to their shareholders.
Bonds also offer a vast range of investment options. The bond market is much larger than that of equities and governments and companies issue bonds all around the world. This choice enhances the potential to counter risks through effective diversification.
How do bonds work?
A bond traded on financial markets is an IOU (‘I Owe You’) issued by a government or a company.
The government or company promises to make an annual payment (the coupon) to the holder of the bond. Normally, an amount called the principal, also known as face or par value, will be given to whoever holds the bond after a pre-set term, such as five, 10 or even 30 years. Sometimes, however, bonds are ‘perpetual’ and never mature.
What risks do bonds pose?
As much as bond prices tend to be more stable than equities, they still rise or fall depending on what the market thinks about the creditworthiness of issuers, expectations of inflation and interest rates.
The coupons that governments or companies pay on their bonds is directly linked to their creditworthiness, or their ability to pay. A multinational firm with a AAA credit rating for example would pay less than a small, less established company that might have ‘junk bond status’.
There are disadvantages to investing in bonds. If the government or company issuing the bond gets into financial trouble, they could default on payments. In this case, the bondholder will get back less money than they expected, or possibly nothing at all.
Bonds are also vulnerable to inflation. Coupons are usually for a fixed nominal amount so their real value will be eroded over time by inflation.
Inflation expectations are priced into bonds but if prices rise more strongly than expected at any stage then bond prices will fall to reflect that the real value of their income streams will reduce.
Some bonds do pay coupons that rise in line with inflation, however. These are sometimes described as ‘index-linked.’
If interest rates in the wider market fall then the price of bonds will go up, and vice versa. If, for example, the central bank reduces interest rates then the revenue paid out on assets in the market will fall. This will make the fixed income provided by bonds more attractive and their prices will rise to reflect this.
