What are bonds and how do they work? - Times Money Mentor (2024)

The global bond market is larger than the stocks and shares market by most estimates. It’s worth an astonishing £100 trillion overall. But how do bonds and the bond market work and are bonds a good investment?

When governments or companies around the world want to raise money, they do it through the bond market. Auctions are held asking if people want to buy the debt at certain interest rates, and then – once bought – that debt can be traded again between different people until it’s paid off.

Bonds remain a core part of a majority of investment portfolios though, particularly among large institutional investors such as pension funds, thanks to their relatively predictable returns.

Also known as the fixed income market, or credit market, the market has been going through a tumultuous period in 2023, as central banks use higher interest rates to rein in inflation.

In this article, we cover:

• What are bonds?
• Are there different types of bond?
• What is the bond market?
• What has been happening in the bond market?
• How can you invest in bonds?

Subscribers to the Times can read more: Bond markets are warning us the party’s over

What are bonds?

Bonds are securities issued by companies or governments in order to finance their spending. They are a form of debt that incurs interest and must eventually be repaid in full.

A bond is essentially a fixed-term loan that has been securitised. This means the loan that has been broken up into many pieces to be sold to multiple investors.

There are two key parts to a bond – the interest it pays and the value of the bond if you were to sell it. The value is worked out by a combination of the value of the debt to be repaid, the interest it pays each year, the number of years left and how risky the debt is seen as.

This contrasts with shares, which raise money through offering partial ownership of a company, rather than creating a debt.

A bond will have a set term length in months or years. Commonly used term lengths are six months, one year, three years, five years and ten years. Longer terms are sometimes used, particularly by governments.The end of the term is also called the maturity.

Read more: When will interest rates go down?

What are yields?

There are two fundamental features of a bond; the price and the yield. The price is self-explanatory – it’s what it would cost to buy the bond. The yield is the amount of interest the bond pays to its owner, expressed as a percentage of the price.

These payments are made at specified intervals, such as quarterly or annually over the course of the bond term.

There is a fixed amount of interest a bond pays each year called the coupon. This is a percentage of the initial price and is set for the life of the bond.

The real yield this coupon produces will fluctuate as the price of the bond moves, because it is a percentage of the bond’s price.

The most important thing to understand is that price and yield move in opposite directions.

As perceived risk goes up the price of a bond falls and its yield rises, with the reverse happening as risk of default falls.

When central banks raise interest rates, this makes debt across the economy more costly to maintain and increases the chance of defaults. Yields therefore rise in general.

Read more: What is money and what do banks do with yours

What are the different types of bond?

There are many variations of bonds, but we there are a few broad categorisations that are useful.

Corporate bondsare issued by individual companies. They issue bonds to finance their activities and investments, from the biggest household names to small, niche firms.

Government bondsare issued by nation states to fund public spending on everything from schools and hospitals to the armed forces. UK-issued government bonds are known as gilts (gilt-edged securities), while US issued bonds are called treasuries.

Mortgage-backed bondsare another important category. As the name suggested, the loans that are broken up into securities are mortgages on properties specifically, rather than general purpose debt.

Another important distinction to be aware of isinvestment grade bondsversus non-investment grade, or speculativebonds. A less flattering, informal way of referring to them is junk bonds.

Read more: What do UK interest rate rises mean for you?

Bond ratings

There are several global ratings agencies that assess the creditworthiness of companies and governments issuing bonds. The main ones are Fitch Ratings, Standard and Poor’s (S&P) and Moody’s.

The ratings are based on how likely the issuer is to pay back the initial payment at the end of a bond term – also known as maturity –as well as make the ongoing yield payments.

AAA is the highest rating possible, followed by AA, A, BBB, BB, B, CCC and so on.

High-yield bonds is the preferred term for bonds that do not receive an investment grade rating of BBB or better. The Moody’s equivalent of BBB is Baa.

These bonds carry a higher risk of default than investment grade bonds and to compensate for that they pay a greater yield to the holder. Yield reflects the level of risk that a bond issuer may default on its obligations to the holder.

Generally speaking, and under normal market conditions, investment grade bonds will have the highest prices and lowest yields, while junk bonds will be the cheapest to buy and offer the highest yield.

Read more: How do interest rates affect inflation?

What is the bond market?

The bond market is where bonds are initially sold and subsequently traded. It is divided into two parts; primary and secondary.

The primary market is where newly created bonds are sold directly to investors by the issuer. They are commonly sold through an auction process where investors submit bids based on their own risk versus reward assessments.

Investment banks such as Goldman Sachs, JP Morgan and UBS will usually create and sell the bonds on behalf of the issuer.

The secondary market is where already existing bonds are traded back and forth between investors. The market itself is largely a network of many brokers doing over the counter (OTC) direct deals with each other, rather than a centralised exchange as with shares. There are some exchanges that offer bond trading though.

Read more: What 4.6% inflation means for your money

How does inflation affect bonds?

A touched on earlier, the base interest rate set by a central bank such as the Bank of England or Federal Reserve directly impacts bond prices and yields.

As rates go up, so do yields because the borrowing money becomes more expensive. This is both in terms of issuing new bonds and paying off existing ones. This also raises the chance of companies or even governments defaulting on their debts, and therefore the perceived risk of bonds increases, which affects how much people will pay.

Bond prices and yields move in opposite directions as we know, therefore prices fall.

In addition, older bonds issued with lower coupons become relatively less attractive than bonds issued in a higher rate environment, so their prices fall.

There will also be better rates available on cash as the base rate rises, reducing the relative attractiveness of bonds.

Inflation is the primary reason a central bank will raise or lower interest rates, so inflation rising will in due course mean bond yields rising and their prices falling generally.

What has been happening in the bond market?

This is exactly what we have seen over the past couple of years. The Bank of England and its peers in the US and European Union have been raising rates aggressively to combat inflation.

This has created uncertainty and volatility in the bond market, with prices in general falling and yields rising.

As central banks move into a rate cutting cycle, which is expected sometime next year, we should see bond prices rise and yields fall to some degree.

This is barring what is known as a “black swan” event, of course. In other words, a completely unexpected and high impact event hitting financial markets across the board.

How can you invest in bonds?

Retail investors can access bonds via the main consumer facing investment platforms.

The most straightforward way is the buy a bonds exchange-traded fund (ETF). This will give you exposure to a broad basket of bonds for a relatively low fee.

For example, you can buy a broad corporate bond ETF, which will give you exposure to a large swathe of big companies’ bonds. There are also government bond ETFs for UK gilts, US treasuries and those of other nations.

There are even high-yield bond ETFs that provide exposure to a basket of companies at the higher risk, higher potential reward end of the scale, as well as mortgage-backed bond ETFs.

As with equities, you could also consider thematic bond ETFs, which tap into a particular investment trend or sector.

Read more: How to invest to try to beat inflation

Active bond funds

Away from ETFs, there actively managed bond funds run by asset management firms. Fund managers supported by analysts will identify what they believe to be the best bonds avaible in terms of their risk level versus expected reward. The aim is to perform better than a broader bond market, for a fee.

Active bond funds can also be tailored to a specific risk appetite at either end of the spectrum.

The other of the main options is to buy into individual bonds directly. This is a more complex endeavour that requires a strong understanding of the market.

If you simply want to invest in UK or US government bonds, that is relatively straightforward for beginner or intermediate investors. It can be done via investment platforms.

However, investing in individual corporate bonds, particularly in the high yield space, is best left to experienced investors who have done significant amounts of research.

Read more: Is now a good time to buy US shares?