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Bonds are a unique asset class, offering investors returns at a lower risk level compared to stocks and shares. Yet they can be mysterious – particularly for new investors. In this guide, our Padiham financial planners explain how bonds work, their distinct features as well as their pros and cons. We conclude with some thoughts on how they can be integrated into an investment strategy. We hope this content is useful to you and please get in touch if you’d like to discuss your own financial plan with us over a free, no-commitment consultation.
What are bonds?
Bonds can be thought of as a type of loan, like between you and a bank. With a normal loan, the bank lends you money upon promise of future repayment (with interest). A bond works like this but almost in reverse. Here, you (the investor) lend money to a company or government when you buy a bond. During the bond’s lifetime, the bond issuer will pay the investor regular interest payments until the maturity date. The latter could be 1 year, 5 years or even 30 years depending on the agreement. Generally speaking, the longer the time horizon, the higher the interest.
How bond investing works
You can buy a single bond directly through an online trading platform. Gilts (UK government bonds) can also be bought via the UK’s Debt Management Office. You can also buy “funds” of bonds, which involves pooling your money together with other investors to buy multiple bonds. These funds differ from many other equity funds (which focus on shares) by offering regular payments to the investors – i.e. interest payments from the fund’s underlying securities. You do not need to hold a bond or bond fund until its maturity date after you purchase it. You could sell your investment to another investor on the marketplace before then, hopefully for a higher price than you originally bought it (e.g. if you need to rebalance your portfolio).
Pros & cons of bond investing
One main benefit of bonds is that they are often a “safer” (lower risk) investment compared to many other investments. A company stock, for instance, could plummet to zero if the business collapses. Yet there is very little risk of the UK government defaulting on its debts – something which has never happened in history. Bonds are also typically less volatile than stocks because more is generally known (and predictable) about their income flows. These features often make bonds attractive to more “cautious” investors who are focused on preserving their wealth.
Conversely, bonds tend to involve a trade-off. The lower perceived risk typically translates to a lower potential return compared to, say, stocks. Indeed, investors need to take care that interest payments from a bond purchase will continue to beat inflation for as long as they hold it. If, for instance, a bond offers a 3% yield but inflation later rises to 4%, then the investor could make a “real-terms” loss of -1%. Bonds are also vulnerable to interest rates. If the Bank of England puts interest rates up (as it has done since late 2021), then the value of pre-purchased bonds often goes down because investors can access better rates from newly-issued bonds. Finally, bonds do not come without risks. In late September 2021, for example, gilt prices fell sharply after the government’s release of its Mini-Budget due to concerns about how tax cuts would be paid for. Prices started to recover after an intervention by the Bank of England.
Bonds and investment strategy
There are ways to mitigate some of the risks involved with bonds. Inflation-linked bonds, for instance, can provide interest payments which rise with inflation (thus helping to protect the real value of your returns). Yet these are also vulnerable to interest rate rises and they may not offer much protection during potential periods of deflation. Overall, the best way to mitigate against investment risk is to diversify your portfolio appropriately. Here, the price mixture of bonds to shares (and/or other assets) will depend on your risk tolerance, investment horizon, investment goals and other key factors.
For instance, suppose you are nearing retirement and so your main priority is to preserve the wealth you have carefully built up and prepared. Your appetite for investment risk might have gone down and you are looking to start taking an income from your portfolio. In which case, it may be time to discuss “re-balancing” your portfolio with a financial planner (e.g. to explore the idea of increasing your ratio of bonds to shares). A younger investor with a long time horizon to invest (and a more “adventurous” risk appetite) may not need many (or any) bonds in his/her portfolio, since greater wealth growth potential is likely to be found elsewhere – such as shares. Regardless of your asset allocation, take care not to make impulsive buy or sell decisions with your portfolio based on emotions and short-term events in the markets. Working with a financial planner can help you adopt and retain a holistic strategy which keeps you moving forwards.
Invitation
If you are interested in starting a conversation about your own financial plan or investments, then we’d love to hear from you. Please contact us to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
Reach us via:
T: 01282 772938
E: info@elmfieldfp.co.uk
