Spin-Free Guide to Bonds

Contents Explaining the world of bonds 3 Understanding how bond prices can rise or fall 5 The different types of bonds 8 Bonds compared with other types of investments 10 How can you invest in bonds? 11 A few questions to ask before you invest in a bond fund 12 Glossary 13 Spin-free guides 15 Please refer to the glossary found on pages 13 and 14 for an explanation of the words highlighted in bold throughout this guide. The value of investments, and the income from them, will fluctuate which will cause the fund price to fall as well as rise and you may not get back the original amount you invested. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to a financial adviser.

Explaining the world of bonds Bonds can seem complicated at times, but if the idea of a regular income appeals to you, it’s worth finding out more about it. If you don’t know your coupon from your credit rating or your principal from your par value, this guide is designed for you. Our aim is to give you the basics, to help you make informed The name’s bond... decisions about your investment aims. Often referred to as bonds, they’re Depending on your situation and your financial goals, investing in bonds could also known as ‘fixed income’ be right for you. But if, after you’ve read this guide, you think you would be or ‘fixed interest’ securities. better suited to something different, there are a variety of other investment It’s likely you’ll come across all options for you to have a look at. These are explained in more detail in our other Spin-free guides; see page 15 for more details. these terms when you read about investments. They all describe the So, what are bonds? same thing, so we’ll just call them A bond is a loan bonds in this guide. When you buy a bond, you are lending money to the government or company that issued it They will give you regular interest payments in return, plus the original amount back at the end of the loan The value of investments, and the income from them, will fluctuate which will cause the fund price to fall as well as rise and you may not get back the original amount you invested. 3

Explaining the Understanding the risks Importantly, there is a chance you won’t be repaid your original investment, world of which is the key risk you face when investing in bonds. It is the reason they are continued considered to be higher risk than just putting your money in a savings account bonds (although bonds are still generally lower risk than investing in company shares, or equities). Where things get a bit more complicated is that bonds can be sold on – just like a company’s shares. This means their price can change. We’ll explain this in more detail on the next few pages. Three words you need to know... Before we go any further, there are three words we need to introduce. They are ‘principal’, ‘coupon’ and ‘maturity’: The principal is the amount you lend to the government or company issuing the bond. The coupon is the regular interest payment that you receive for buying the bond. It is often a fixed amount that is set when the bond is issued. Maturity is the date when the bond expires and the principal is repaid. Returns from bonds Income: coupons You know exactly how much you’ll receive and when, assuming the issuer doesn’t miss payments. Capital return If you buy a bond from another investor for less than its original cost, you could make a profit by holding it to maturity. 4

If you buy a bond when it is issued, you pay a fixed price. However, after it is issued, you Understanding how can trade the bond with other investors, much like you can with shares. When you buy or bond prices can sell a bond in this way, its ‘market’ price will be affected by a number of factors. rise or fall Here we look at the four main influences on bond prices. 1. How interest rates affect bonds Now imagine that the Bank of England decides that The interest rates paid by banks and building societies the economy is growing too fast and decides to raise normally follow the official interest rate set by the Bank the official interest rate, causing the rate on the savings of England. The Bank of England uses this rate as a tool account to move up as well, to 2%. Suddenly, the 1.25% to manage the UK economy. on the bond doesn’t look as appealing, so its price is likely to fall. Equally, if the Bank of England cuts interest rates, When times are tough, interest rates tend to be cut in the the interest on the bond becomes more attractive, so its hope this will encourage consumers to spend, businesses to price may rise. borrow and, through this process, kick start the economy. 2. How inflation affects bonds If things are going well, and consumer spending, as well Things tend to get more expensive over the years. This as bank lending, are starting to look too strong, the Bank rise in prices is referred to as inflation. When inflation is of England could raise the interest rate to slow things high, it can be a problem for bonds because the income down, and reduce the demand for borrowing. they pay has normally been fixed at the time of issue. Normally, bond prices tend to move in the opposite A bond that offers interest of 5%, for example, may sound direction to interest rates. We can illustrate this with a good in isolation, but if inflation is running at 4.5%, the simple example. Imagine you had a choice between a real return, or return after adjusting for inflation, is only savings account that pays interest of 0.5% and a bond 0.5%. This means bonds tend to become less attractive that offers you interest of 1.25%. In choosing where to (and prices fall) when inflation is rising. invest your money, you’d have to take into account the higher level of interest paid by the bond and decide On the other hand, if inflation is falling, a fixed interest of whether it is worth the greater level of risk it involves. 5% becomes a lot more appealing. Therefore, in a situation We’ll look at this risk in more detail on pages 8 and 10. where inflation is falling or low, bond prices tend to rise. 5

Understanding how bond prices can rise or fall continued 3. How an issuer’s prospects 4. How supply and demand affectbonds affectsbonds Some companies find it financially easier than others If a lot of companies or governments suddenly need to to pay their debts. This ability to repay is measured borrow, there will be many bonds for investors to choose by their credit rating, or creditworthiness. It is an from, so prices are likely to fall. On the other hand, if assessment, carried out by independent rating agencies, more investors want to buy than there are bonds on offer, of a borrower’s ability to repay its debt. A higher rating prices are likely to rise. means a company is very likely to meet its payments. What drives the value of bonds up On the other hand, if a company’s financial situation or down? weakens, its credit rating will be downgraded, as there is a greater chance that the company will struggle to make VALUE INCREASES: More investors want to buy, but its payments. As a result, its bond price will often fall, fewer bondholders want to sell. as investors decide that the income offered by the bond isn’t enough to make up for the fact that it is now riskier. VALUE DECREASES: More bondholders want to sell, but The same is true for governments, which are also given fewer investors want to buy. credit ratings by rating agencies. Governments in the developed world, such as the UK or the US, are generally Bonds can be traded like shares considered to be more likely to meet their payments than governments in some developing countries, and so This means their prices can go up or down, tend to be given a higher credit rating than the latter. A depending on a number of factors change in a government’s financial health will therefore These factors include interest rates, inflation and affect its credit rating and, in turn, the price of its bonds. the economic outlook 6

Understanding how Bonds normally pay a pre-agreed regular income bond prices can You should then get the initial investment back when the loan expires rise or fall continued Are bonds right for you? Achieving some growth A key advantage of investing in bonds is that you could As we explained on pages 5 and 6, there are a number receive a stable income and your original investment of factors that can cause the price of a bond to go up or back at the end of the loan. There is also the potential down. While this rise or fall tends not to be as significant for a profit if you sell the bond at a higher price than you as the changes in price that you see with shares, it could paid when you bought it. still allow you to make a profit on a bond if you buy and sell it at the right time. Equally, if a bond falls in value and A stable income you buy it for less than its original cost, you could hold it Because the interest is fixed when you buy a bond, you’ll to maturity and you would make a profit in addition to generally know exactly how much you’ll receive and when any income you receive. (In both cases, it is also possible it will be paid. If you are relying on your investment for to make a loss.) income, the regular interest payments from bonds can The value of your income make it much easier for you to plan ahead – though there Because the price of a bond can change, but the income is always a chance the company or government who you payments are fixed, the return on the bond (often referred have lent your money to will fail to keep up the payments. to as the yield) can vary. For example, a bond issued at Preserving your savings £1 with a 5p coupon, has a yield of 5%. However, if the If you hold your bond for the life of the loan (and nothing price rises to £2, the coupon is still 5p, so the yield falls goes wrong in the meantime), you should get back what to 2.5%. This means that if you are buying bonds from you originally put in. It’s as simple as that. other investors and you need a certain level of income, the price you pay is very important. 7

The different types of bonds Choosing between the different Corporate bonds types of bonds Corporate bonds are issued by companies when they need to raise money to finance their business, or to repay There are many different kinds of bonds in the market, other loans. They are often considered to be higher risk so it’s important to know exactly what you want from than government bonds, because companies generally your investment. In particular, there’s one question you are more likely to have problems paying their debts. need to consider. Are you willing to take on more risk, with the aim of achieving more income, or do you want to keep things as safe as possible? Your answer will help you decide which types of bonds are right for you. The two main issuers of bonds are governments and You can lend money to a companies: country (a government bond) or to a company Government bonds (a corporate bond) Government bonds are issued by countries, normally to raise money for public spending. Among the biggest A higher level of issuers of government bonds are the UK government interest normally means (UK government bonds are also known as gilts), the US a higher level of risk government (their bonds are known as Treasuries) and the German government (bunds). Governments with solid public finances are generally regarded as low risk, as they are less likely to fail to keep up the payments. Therefore, they tend to pay very low coupons, or interest. 8

The different types of bonds continued Bond issuers are normally graded according to their ability to repay their debt. Investment grade bonds A company or government with a high credit rating is While the majority of bonds that are issued pay a fixed considered to be ‘investment grade’. This means you’re level of interest, there are others that pay a flexible rate, less likely to lose money on their bonds, but you’ll probably or adjust their payments in line with inflation. get less interest as well. Index-linked bonds High yield bonds As we mentioned on page 5, inflation can be a real At the other end of the spectrum, a company or problem for bond investors. One possible solution for government with a low credit rating is considered to be investors worried about changes in the inflation rate is index-linked bonds. ‘high yield’. As the company or government issuing them offered by has a higher risk of failing to meet their repayments, The value of the loan and the regular income payments they have to offer a higher level of interest to encourage you receive are adjusted in line with a particular measure people to buy their bonds. of inflation (in the UK, this is usually the Retail Prices Index). This means that when inflation is rising, your coupon payments and the amount you get back will go up in line with the inflation rate, and vice versa. 9

Cash savings are the safest way to invest, but they also have the Bonds compared least chance to grow with other types of Bonds offer the potential for a regular income and tend to be lower investments risk than property and equities Equities (also known as shares) are part-ownership of a company, so you have a share in its profits. They are higher risk than property, bonds and cash, but they also offer the greatest potential for growth Where could you invest? When it comes to choosing where to invest, the option It is possible to create what’s called a ‘diversified you go for is likely to depend on how you feel about risk portfolio’, meaning an investment portfolio that is made and what you need from your investment. up of a combination of some or all of cash, equities, Cash grows only by the interest rate applied to the bonds and property. This might offer more stability savings account. However, it is the most secure home for through the ups and downs in markets and economies, your money. Up to £75,000 of your money is secure in because different types of investments tend to rise or a bank or building society through the Financial Services fall at different times and at different rates. Compensation Scheme, unlike stocks and shares or fixed interest investments, which are less secure. Bonds are generally lower risk than equities and provide a regular income, with more growth potential than cash. Property offers the combination of a stable, long-term income and potential for some capital growth through investing in ‘bricks and mortar’ assets. Equities have the potential for strong growth, but also come with the possibility for greater losses. 10

How can you You can invest directly in bonds You can put your money into a fund where the fund manager chooses invest in the bonds bonds? There are many different types of bond funds to choose from The different ways you can invest in bonds While it is possible for you to buy bonds yourself, it’s not the easiest thing to do and it tends to be quite expensive. An expert perspective Pooling your money Investors may find that it’s much more straightforward You can pool your money with other investors to buy a fund that invests in bonds. This has two main to buy a range of bonds, diversifying your advantages: investments to reduce exposure to any one government or company. Your money is combined with investments from lots An experienced fund manager invests and manages of other people, which means it can be spread across on your behalf. An active manager typically aims to a range of bonds in a way that you just couldn’t do if outperform other similar bond funds. you were investing on your own. Because of the mix of investments, however, bond funds cannot promise a fixed income over time. Funds are normally managed by professionals who are backed by all the research resources of an investment company. This helps them find the best opportunities and avoid bonds that may have problems down the line; however, there’s no guarantee of course that they will be successful. 11

A few questions to What sorts of bonds does the fund invest in? ask before you invest How does the fund manage risk? in a bond How does the manager determine which bonds to invest in? fund Picking a fund that meets to repay its debt. Different bonds are affected differently yourneeds by changes in these two key factors. Before you invest, it’s worth making sure the company managing your bond The names of bond funds can sometimes reveal very fund has the knowledge, experience and resources to little, so it’s a good idea to get a sense of the potential monitor these challenges and make changes whenever risks of a fund by looking at the types of bonds it invests they are required. in and what the average credit rating is of its bond holdings. For example, you can choose between funds Finding out how your fund that invest purely in government bonds, funds that manager’s investment company invest in investment grade corporate bonds, or funds that invest only in high yield bonds, or you could choose researches opportunities a fund able to invest in all the different types. There are few people who would lend money to someone without knowing anything about them. Investing in Checking how the manager bonds is just the same. If your fund manager’s investment produces an income company has its own team of analysts, they can carry Income on a bond fund is produced by the regular coupons out their own in-depth research into the bonds they paid by the bonds held in the portfolio. As you probably might hold. expect, you have to pay for the management of any bond This means they aren’t relying solely on information from fund you invest in. The way these charges are handled will credit rating agencies, which is available to everyone. affect the total income you get. Some funds take their With greater insight, a well-resourced investment team charges from income before it is paid out to you, while should be able to make more informed decisions on others take it from the amount you originally invested. your behalf. Making sure you are happy with the way a fund manages risk The returns from bonds are primarily influenced by changes in interest rates and the ability of the borrower 12

Glossary Investment terms The following are explanations of some of the terms you would have come across in this guide. Bond Credit rating Fixed income security A loan in the form of a security, usually issued by An independent assessment of a borrower’s ability A loan in the form of a security, usually issued by Aa government or company, which normally pays a to repay its debts. A high rating indicates that the a government or company, which normally pays a fixed rate of interest over a given time period, at the credit rating agency considers the issuer to be at low fixed rate of interest over a given time period, at the end of which the initial amount borrowed is repaid. risk of default; likewise, a low rating indicates high risk end of which the initial amount borrowed is repaid. Bunds of default. Standard & Poor’s, Fitch and Moody’s are Also referred to as a bond. Fixed income securities issued by the German the three most prominent credit rating agencies. Gilts government. Default means that a company or government is Fixed income securities issued by the UK government. unable to meet interest payments or repay the initial Capital return investment amount at the end of a security’s life. Government bonds The term for the gain or loss derived from an Default Fixed income securities issued by governments, investment over a particular period. Capital return When a borrower does not maintain interest that normally pay a fixed rate of interest over a includes capital gain or loss only and excludes income payments or repay the amount borrowed when due. given time period, at the end of which the initial (in the form of interest or dividend payments). investment is repaid. Corporate bonds Diversified/Diversification High yield bonds Fixed income securities issued by a company. The practice of investing in a variety of assets. This Fixed income securities issued by companies with a low They are also known as bonds and can offer higher is a risk management technique where, in a well- credit rating from a recognised credit rating agency. interest payments than bonds issued by governments diversified portfolio, any loss from an individual They are considered to be at higher risk of default as they are often considered more risky. holding should be offset by gains in other holdings, than better quality, ie higher-rated fixed income thereby lessening the impact on the overall portfolio. securities but have the potential for higher rewards. Coupon Equities ‘Default’ means that a company or government is The interest paid by the government or company Shares of ownership in a company. unable to meet interest payments or repay the initial that has raised a loan by selling bonds. investment amount at the end of a security’s life. Face value The initial price of a bond, also known as par value. continued on next page 13

Glossary continued Inflation Issuer Risk The rate of increase in the cost of living. Inflation is An entity that sells securities, such as fixed income The chance that an investment’s return will be different usually quoted as an annual percentage, comparing securities and company shares. to what is expected. Risk includes the possibility of the average price this month with the same month a Maturity losing some or all of the original investment. year earlier. The length of time until the initial investment amount Total return Inflation-linked bonds/Index-linked bonds of a fixed income security is due to be repaid to the The term for the gain or loss derived from an investment Fixed income securities where both the value of the holder of the security. over a particular period. Total return includes income loan and the interest payments are adjusted in line Par value (in the form of interest or dividend payments) and with inflation over the life of the security. Also referred The initial price of a bond, also known as face value. capital gains. to as index-linked bonds. Treasuries Investment grade corporate bonds Principal Fixed income securities issued by the US government. Fixed income securities issued by a company with a The face value of a fixed income security, which is medium or high credit rating from a recognised credit the amount due back to the investor by the borrower Yield (bonds) rating agency. They are considered to be at lower risk when the security reaches the end of its life. This refers to the interest received from a fixed from default than those issued by companies with Retail Prices Index (RPI) income security and is usually expressed annually as a lower credit ratings. Default means that a company A UK inflation index that measures the rate of change percentage based on the investment’s cost, its current or government is unable to meet interest payments of prices for a basket of goods and services in the UK, market value or its face value. or repay the initial investment amount at the end of a including mortgage payments and council tax. security’s life. Z 14

guides This brochure is part of our range of spin-free guides: Spin-free guides aim to give you the basics about investing, to help you make informed In vesting Eq uities decisions about your financial goals and how to reach them. The value of investments, and the income from them, will fluctuate which will cause the fund price to fall as well as rise and you may Risk I ncome not get back the original amount you invested. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to a financial adviser. The views expressed in this document should not be taken as a recommendation, advice or forecast. Bond s Pr operty Multi -asset investing 15

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