Beginner's guide to bonds
Fixed rate, corporate, retail, mini: if you're confused about the different types of bond, we explain how they all work.
The common theme with bonds is that you’re effectively lending money to an organisation or country for a period of time. In return, you’ll be paid regular rewards – normally interest – during the period of the loan, and then you’ll get your money back at the end.
However, the safe return of your money can’t always be guaranteed and the level of risk depends on what kind of bond you have. Let’s look at the different kinds of bond and how much risk is involved.
Cash bonds
Cash bonds are a type of savings account, often known as a fixed rate bonds. You invest a lump sum in one of these bonds and your money is locked away for anything from six months to five years, during which time you earn interest.
Generally speaking, the longer you lock your money away for, the higher the interest rate.
Money deposited with a bank or building society in a cash bond is protected by the Financial Services Compensation Scheme (FSCS) for amounts up to £85,000 per person, per institution. This means if a financial institution fails, you will get your savings back.
Interest rates on these bonds are normally fixed and if you want to withdraw money early, you’ll usually have to pay a penalty.
Financial purists would say that cash bonds aren't true bonds, they'd reserve that term for government and corporate bonds. So let's look at bonds offered by governments.
Government bonds
Governments around the world issue bonds to raise money, including the UK where they’re also known as gilts. They can be conventional bonds (with fixed income payments) or index-linked bonds (payments change according to inflation).
You can buy bonds when they’re first issued by a government or buy them from other investors on the markets. That’s one of the great attractions of government bonds, you can easily sell your investment via the markets. That said, you may not get back the price you paid.
The price of government bonds is driven by several factors but risk is probably the most important. For example, investors are understandably nervous that Greece may not be able to pay back all of its debts, so the price of Greek government bonds has fallen and the yields have gone up.
US and UK government bonds are usually regarded as safer bets, so the price of these bonds has risen in recent times.
If you want to buy new gilts at a gilt auction, you can find out when the next issues are via the Debt Management Office (DMO).
Then if you wish to buy, you’ll have to register with Computershare, an agent of the DMO. You’ll also have to be accepted onto the Approved Group of Investors – essentially that’s to verify who you are and to check you have the funds.
This is all a bit of a palaver, so it may be simpler just to buy gilts that have already been issued. You can do this via a stockbroker or a bank.
Your other option is to put your money in an exchange traded fund (ETF) that invests in gilts. You can find a list of such funds at the Investing in funds website. These funds can be put into an ISA or self-invested personal pension (SIPP).
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Retail and corporate bonds
Corporate bonds are similar to government bonds except they’re issued by companies. Because companies are normally seen as riskier bets than countries, you’d normally expect corporate bonds to pay a higher interest rate than a government bond.
Until recently, few private individuals bought corporate bonds, but that’s changed as several companies have launched corporate bonds that are aimed at ordinary people. These bonds are often known as retail bonds. Over the last couple of years, retail bonds have been launched by Tesco, National Grid and John Lewis amongst others.
Corporate and retail bonds can be a good way to lock in decent returns but there is no certainty that your money is safe. Big brand names like Tesco aren’t regarded as companies likely to default, but you still have to appreciate there is some risk. Unlike savings bonds, government and corporate bonds are investments and are therefore excluded under the FSCS.
It’s worth noting that as a bondholder, you would stand ahead of shareholders in the queue for your money back if a company were to go under. But if the company’s debt is very large, there could still be nothing left for bondholders either.
Corporate bonds are available via investment platforms such as Hargreaves Lansdown and TD Direct Investing, stockbrokers and the Order book for Retail Bonds (ORB), which launched by the London Stock Exchange in 2010.
The ORB is an electronic platform that allows private investors to trade fixed-income securities (the City name for bonds).
Another way to invest in corporate bonds is to spread your risk by buying into a corporate bond fund, which invests in a wide range of company bonds. These can also be bought via an investment platform.
Bonds can be put into a stocks & shares SA or self-invested personal pension (SIPP).
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Mini-bonds
Small companies trying to bypass banks and expensive business loans are increasingly looking to their fans or customer-base to raise capital.
In return they’re offering perks, discounts or free stock instead of traditional interest payments.
But with these types of bonds there is no safety net if the company fails. You might get less interest than was promised, none at all, or in the worst case scenario you could lose your original investment. Your money won’t be covered by the FSCS.
With this type of bond you invest directly with the company. They crop up intermittently and you have to be on the lookout for them. We sometimes feature bonds from more well-known companies.
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This is a classic lovemoney article that has been updated
More on investments:
Beginner's guide to stocks & shares ISAs
Beginner's guide to index tracker funds
Beginner's guide to Exchange Traded Funds
Beginner's guide to managed funds
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