Bonds

Gilts – UK government bonds – have hit the headlines this week on news of a dramatic fall in the real yield of long-dated issues. The real yield – the return over and above inflations – on the 50-year index-linked gilt plunged to a low of 0.38 per cent at one point. This matters because pension companies calculate their liabilities using a discount rate based on bond yields.

The gilt market’s attachment to archaic terminology can obscure its relevance. Consols and war loans hark back to when the City was dominated by middle-aged men in bowler hats. Today youngsters in open-neck shirts deal in sums equivalent to the gross domestic product of a small country. The market can trace itself back to 1694, when the Bank of England was created to raise funds to fight the French. Yet for many people bonds remain a mystery.

So what are bonds?

Bonds are interest-bearing securities issued by governments, financial groups and industrial companies. They represent a longer term form of finance compared with the money markets or bank loans. Usually they have maturities of up to 30 years although governments and some companies have recently issued 50-year bonds. Some issues are perpetual – they have no redemption date. Because bonds are tradeable, they are a flexible form of finance and allow the borrower to tap a wider spectrum of investors. They can be held until maturity or sold at any time during their life on the secondary markets.

Bonds come in a variety of forms: sovereign, this is a government issue, referred to in the UK as gilts; or corporate. They can be investment grade, which means they are issued by financially strong companies, or sub-investment grade, otherwise known as high-yield or junk. They usually pay a fixed rate of return but some are floating or indexed to inflation. Some – convertibles – carry a conversion right into a company’s shares.

How do they differ from shares?

Bonds pay a regular level of interest – referred to as the coupon – which, in theory, is guaranteed, unlike shares’ dividends that can be cut or suspended. Bondholders are paid out ahead of shareholders in the event of a default. But while shares have, in theory, unlimited upside, bonds will at best earn a pre-determined rate of return no matter how well a company is doing or how strong the economy of a country is.

Bonds often carry a rating. What does this mean?

Ratings agencies – Standard & Poor’s, Moody’s and Fitch are the three largest – play an important role in assessing bonds. They measure the likelihood of default, operating a ratings scale that runs from D (default) to triple-A for the most sound of issuers. Moody’s uses a slightly different ratings method. What S&P and Fitch rate as AAA, Moody’s describes as Aaa. Any rating of triple B minus and above – Baa3 for Moody’s – ranks as investment grade. Anything below is high yield or junk.

Why have bonds become more high profile recently?

The collapse of the equity markets between 2000 and 2003 made it unattractive for companies to issue shares while governments struggling to cover deficits have turned to the bond markets. The stock market slump also made pension funds aware of the risks of investing too heavily in shares. Pressure from the pensions regulator to match assets more closely with liabilities meant many had to increase their bond holdings.

Should I stick to government issues or consider corporate bonds?

Government issues should be safer because, in theory, governments cannot go bust. But both Argentina and Russia have defaulted on their bonds in recent years so this is no absolute guarantee. The corporate bond market offers a wider choice of investments but many issues are quite small and so can be difficult to buy or sell, particularly in larger quantities.

Press coverage of the stock markets tends to focus on share prices but bonds are usually written about in terms of yields. Why is this?

Bond yields clearly reflect prices. When bond prices go up, their yields go down. Bondholders are most interested in the yield as this normally represents the biggest element of the total financial return. Yields therefore are a useful way of denoting bond values.

How can I invest in bonds?

Gilts can be bought at auction by registering as an approved investor through the Debt Management Office (www.dmo.gov.uk) or with Computershare (www.computershare.com), which handles sales for the government. Gilts can also be bought in the second-hand market through a bank or a broker.

Corporate bonds are trickier because issues are usually syndicated and snapped up by the big investors. This leaves unit and investment trusts as the retail investor’s main way into the market. Bond funds account for about 15 per cent of private investor money tied up in funds such as unit trusts and Oeics, though less favourable tax treatments means they account for just 2 per cent of investment trusts.

A recent development has been the creation of retail programmes or “platforms” by several large banks including Bank of America with Internotes, Deutsche Bank with Coins and ABN Amro with EuroDans. These offer medium-term notes or bonds in manageable denominations – usually €1,000 or $1,000. Details of the note offer are announced on a Monday and the coupon or interest rate is held for the rest of the week. This gives investors time to assess the issue. The notes are priced at par to simplify the yield calculation.