how bonds work

How bonds work and are they a good investment

It’s the same as lending money to your friend, this is how bonds work. There’s only one difference, your friend repays you the principal at the end and some interest in the mean time.

Oh, and another one, you are not lending to your friend but a government or a company.

Think of an interest only mortgage where you are the one issuing the loan.

What is a bond

Bonds are one of the ways governments and companies raise money. When you hear about a country’s debt on the news the presenter is actually talking about fixed interest government bonds.

That’s why bonds are called a fixed income security. There are some floating rate notes, bonds with a variable interest rate, however, they are less common.

Government bonds

When a government needs money it issues bonds also called gilts here in the UK. They come in chunks, £1,000 for example, called principal with different maturities and interest rates, and can be in different currencies depending on the issuer.

The maturity can be between a few months and 30 years and the interest rate can vary from negative to over 30%. There was a good deal on Zambian bonds at 35% interest a few months ago but it was very risky.

Generally, the lower the risk the lower the interest you get. Sorry, there’s no free lunch.

So instead of lending your friend £1000 you can buy a 10 year bond and support your country. Let’s assume it’s a government bond with a 5% interest rate.

You’ll get £50 each year for 10 years and at the end the government will repay you back your initial £1,000. These are the basics of how bonds work.

Corporate bonds

Companies issue bonds too and they offer higher interest rates than the government. However, the risk of bankruptcy is much bigger than that of a country.

Having said that Argentina has defaulted on its debt 9 times over the past 200 years!

If you own a corporate bond you get paid before the shareholders in case of bankruptcy. You’ll have to wait for the banks to get their money first, after that it’s your turn as a bondholder and the poor shareholders are at the end of the queue.

This would only be true if there is any money left to collect, you may still end up with nothing. There are secured bonds for the more risk averse where the company offers some kind of collateral.

The collateral works the same as paying a deposit to book a table at a restaurant. If you don’t show up the restaurant can recoup some of the loss.

Cash is also a bond

I can give a £20 note a fancy name: a zero-coupon bond. All that means in English is that I have given something, say work, to receive the note.

I get 0% interest on that note but the UK government has promised me that I can go to any store and buy stuff with it. This makes it a bond as I can’t pay in old newspaper articles.

If you’ve heard of hyperinflation you know that this is a situation when a currency quickly becomes worthless. For example, I go to the store and buy a loaf of bread for £1.

However, the next day the price is £1.50. I have to go back home and bring some more cash. That’s exactly what happens to people in Zimbabwe and it’s not fun. There are similar issues which happen to bonds.

Can you explain the purchase of a bond in a really weird way

Yes, I can, thanks for asking! When you buy a bond you are selling cash with the expectation that the cash will drop in value due to inflation. If you thought otherwise you’d just keep the money.

On the other hand you expect that the bond will bring in more cash than the amount you paid because you get interest payments.

So you are short cash and you are long a bond. That’s the case when you buy a loaf of bread too, you sell cash because you feel that being hungry is worse than having a pound in your pocket.

It gets worse when you buy a laptop and then you see it £50 cheaper in another store. It turns out the cash was worth more than you thought.

All of these real life examples work exactly the same as buying and selling financial securities.

Advantages of bonds

There are many good things about bonds. They are called fixed income for a reason, you know what you get well in advance. You don’t care about market crashes or share prices moving around. Consequently, they are low risk compared to stocks.

You are promised a payment by a national government. If we are talking about a UK gilt, the chance of a default is pretty slim. And if there is one, believe me a bond investment will be the last thing you’d care about.

The added benefit is that bond prices go up when stocks go down so you wouldn’t do bad during a market crash. You need to be aware that this relationship is not as strong as it has been in the past.

Bonds are also easy to buy and sell. They are expensive but the market is big so many exchange traded funds offer them. You can get started with bonds from £30 or maybe even less!

There are rating agencies which publish the risk of default of different bonds. It is denominated in letters, for example: AAA, AA, A, BBB, BB, B, CCC, CC, C and D. The UK’s bond rating is quite high at AA, while Zambia’s is between CCC and C.

You need to be careful with these ratings as they can lag a bit. If you remember 2008 you’d know that there was an issue with their validity prior to the market crash.

There is no doubt that you normally get a higher interest rate from a bond than a savings account.

I said that bonds are fixed income right? What if I told you that you can sell them at some point and make money. The flip side is that you can lose money too. I’ll get on to that in the disadvantages section.

Disadvantages of bonds

I already said that there can be a default, yes the risk is minor for a lot of countries but it is out there. Who would have thought that the Roman Empire would come to an end.

The risk of default is even higher for individual companies. There are funds which offer a basket of investment grade (read high credit rating) bonds. You can reduce your exposure by using one of these.

Interest rate

Interest-rate risk is a big issue. What if you bought a bond and agree to receive 2% for 20 years. A few years go by and all of a sudden the interest rate goes up to 5%.

You’d be gutted and you may think ok, I’ll just sell it and buy the new bond. Unfortunately it doesn’t work like that because your bond will be cheaper.

You’ll need to sell it at a loss or watch everyone else make 5% per year while you make 2%. It could work the other way around and you could make money but we can’t know how, if or when the price will change.

As a general rule, if we are talking about a stable economy like the UK, US or Germany for example you’d be better off buying bonds when the interest is high.

I just said that but it has no practical use as I can’t tell you when the government will decide to raise the interest rate. Normally, it will happen when the economy is booming which is also of little practical use for the same reason.

The credit rating of a country can change. The UK had an AAA rating which was downgraded to AA. Such an event can cause a decline of the bond’s value. The risk is higher so others don’t want to buy it anymore or at least not at a high price.

Some corporate bonds are issued with an early repayment option and you may not collect all the anticipated interest payments.

Inflation

Bonds don’t necessarily keep up with inflation. If you buy at 2% and inflation goes up to 3% you lose money. This is a result of the fixed income component.

Compare this with a stock. The company you own can adapt by increasing the prices it charges for products and services. This is not always the case but think about how much you paid for stuff 10 years ago and how much you pay now. Check out the difference in iPhone prices: iPhone 4 was $299, iPhone X was over $1,000.

Example of a loss or gain depending which side you are on

This is a very easy example to help you understand how gains and losses work. They occur if you sell the bond. If you hold it to maturity you will get what you are promised.

Assume that I bought a 1 year bond for £1,000 and the interest payment is 5% or £50 due in 6 months. The total value of the bond is £1050.

A day after I bought it the interest rate went up to 10% (or £100 in the example) so the new £1,000 bond is actually worth £1,100.

No one would want to buy my bond for £1,000 anymore but if I offer it for £950 someone may be interested.

In this example the buyer will pay me £950 and will collect £50 interest and £1,000 principal. The new owner will earn 10.5% which makes the deal worthwhile. I on the other hand will realise a 5% loss.

Which is better stocks or bonds

None of the previous sections answer the question should I buy shares or bonds. You can always buy both. When it comes to investing the only clear answers are in the past.

The problem is that thinking if I had bought XYZ 10 years ago doesn’t improve future returns.

Normally stocks outperform bonds but this hasn’t been the case in the UK market the past 5 years as I wrote here. Stocks and bonds come with different risk profiles so you need to do whatever fits your needs.

A lot of investors choose to mix the two so they know that if their stocks go down the bonds will go up and vice versa. I have some more advanced content on this subject here.

Conclusion

There may not be any clear answers but at least you know how bonds work. Any investment will carry risk, however, government bonds issued by stable economies are one of the more robust financial securities.

They can be good for speculation too but then you may be faced with the same risk as company stock or worse. Whatever you choose it is important to do your homework first, set some goals and see if bonds fit your needs.

Here at The Stock and Options Spot it’s always about the bottom line so whatever the case give yourself the best chance to make some money.