We are all told we should have bonds in our portfolios – for diversification, to reduce volatilty, for safety …
As a financial concept, a bond is easy to understand – far more so than shares (at least conventional bonds are but Index-Linked bonds are a story for another day). You purchase a bond issued by a company or a government at a certain price, it pays a fixed amount of money as interest at defined dates every year, and finally at a set date when it matures you receive a sum of money equal to its face value. So as an example a Famous Company PLC 4% June 5th, 2022 bond with a face value of £100 will pay £2 in interest every 6 months until June 5th, 2022 at which point you will receive £100
The bond is traded exactly like a share so its value varies according to interest rates and how secure the company or government is perceived by the markets and rating agencies such as Standard and Poors. So the price you pay for the bond will probably not be its face value. If general interest rates are much higher than 4% the bond will sell for below its £100 face value and if rates are much lower it will sell for higher than £100. But the amount it pays out in interest per £100 bond stays the same, and the final payout of £100 stays the same. During its life, its market price will vary but as it approached its redemption date its price will get closer and closer to £100
So a bond if bought and held until redemption is highly predictable. You know exactly how much you will receive in interest and exactly the final payout. Prices for bonds are usually quoted together with two yield figures – the Flat Yield which is the annual interest payout divided by the current price of the bond and the Redemption Yield which is your total return assuming you keep the bond until redemption. The only risk is that the company or government goes bust or just decides not to pay out – just like a share. The interest rate on a bond reflects the apparent risk so an AAA-rated bond pays out less than a CCC-rated bond. Bearing in mind that the financial crisis of 2008 was largely caused by rating agencies giving investment-grade ratings to packages of sub-prime (ie junk) mortgages insured by AAA-rated insolvent Insurance Companies then not all is a simple as it would seem.
OK so with the exception of the credit risk issue which is the same as for shares you pretty well know what you are getting. Put together a portfolio of bonds from sound companies and governments the risk is spread you know exactly what income you will receive and when. Unfortunately, bond trading is not as easy as share trading. Firstly whilst there are hundreds of financial websites that give access to share prices, company statistics, finances, and analysts’ reports, this is not the case for bonds. Fixed Income Investor is a good starting point for UK bonds and also London Stock Exchange has a pretty good selection tool where you can define selection criteria such as flat yield, gross redemption yield, and duration.
Most investors will buy bonds via collective investments such as funds or ETFs and here the simplicity and transparency of purchasing individual bonds and holding them to maturity ends.
At the point you invest you will know some important facts about the investment – the flat yield, yield to redemption, average maturity, and of course historic performance but there is absolutely no certainty about what will happen further on in time as unlike an individual bond there is no concept of “maturity”. A fund will have bonds reaching maturity which will have to be replaced at current market prices and will have investors putting money in or withdrawing which again means purchases or sales by the fund manager.
So the concept of a bond as a source of certainty is far from true when one invests through collective investments. I currently only have a tiny proportion of my portfolio in bonds at the moment but when
I start to build up my holdings ove the next few years I shall certainly be building up a portfolio of individual bonds and gilts to give my portfolio a higher degree of predictability.
