On the face of it, bonds might seem like straightforward investment products. Once you dig deeper, it is easy to get confused with the language around how they work. Fear not, as we are here to help.
To help you better understand the world of bonds, we have compiled answers to seven frequent questions that investors ask.
Getting your head around how bonds work and what the different terms mean could help you decide if bonds are right for you, and if so, which types of bonds you might want to own.
1. What return should I expect from bonds?
Over the long term, bond returns are typically lower than shares but higher than cash. A useful rule of thumb is that a bond’s yield at the time of purchase is a good guide to its expected future return if you hold the bond to maturity.
The returns will vary across different bond types, and they depend on factors such as credit quality, the number of years until the bond matures, and interest rate movements.
Typically, bonds with longer maturities tend to offer higher yields than shorter-dated bonds to reflect the higher risks associated with lending money for longer periods. However, this is not always the case. Remember that bonds are effectively IOUs where the investor lends the issuer money in return for regular coupon payments and then gets that money back if and when the bond is redeemed.
2. Can I lose money in bonds?
Yes, you can lose money, even though bonds rank as a low-risk investment.
Bond prices can fall if interest rates rise, credit quality deteriorates, or you sell before maturity at a price lower than you paid. Investors can also lose money if the issuer defaults and does not pay the interest or cannot redeem the bonds at maturity.
3. What happens if a company or government defaults on a bond?
Bondholders may get back part of their money through a restructuring, liquidation, or debt-recovery process, but there is no guarantee. You could get back part of your money or nothing at all.
Bondholders typically rank ahead of shareholders in a default situation, meaning they are usually paid before shareholders receive anything.
If a company cannot repay its debts, the amount bondholders get back depends on the value of the company’s assets and where their bond ranks in the repayment queue. Certain bonds have a higher claim on the company’s assets than others, so investors in those bonds are more likely to recover a larger share of their money.
There is no liquidation process with government bonds; instead, recoveries usually depend on debt restructuring negotiations between the government and its creditors.
4. How safe are UK gilts?
UK gilts are backed by the UK government and are viewed as among the safer investments available to investors.
The risk of the UK government failing to repay its debts is viewed as low. However, gilt prices can still rise and fall, meaning investors can make a loss if they sell before maturity at a price lower than they paid. Inflation can also erode the real value of returns.
5. Why do bond yields rise or fall?
Bond yields are influenced by expectations for interest rates, inflation, economic growth and investor demand.
Strong economic growth and rising inflation expectations often push yields up, as investors anticipate higher interest rates. Weaker growth or expectations of interest rate cuts can pull bond yields down.
Bond prices and yields move in the opposite direction. When yields rise, existing bonds with lower coupons become less attractive compared with newly issued bonds, so their prices tend to fall. When yields fall, existing bonds with higher coupon rates become more valuable, causing their prices to rise.
6. What happens to bonds when interest rates rise or fall?
Bond prices and interest rates usually move in opposite directions. When interest rates rise, existing bond prices tend to fall because newer bonds offer higher rates of interest. When interest rates fall, existing bond prices tend to rise because their interest payments become more attractive.
Duration is a measure of how sensitive a bond’s price is to changes in interest rates. Bonds with longer durations tend to experience larger price movements when interest rates change.
7. How does inflation affect bonds?
Inflation erodes the real value of future interest payments and the money you get back when the bond matures, which can make fixed-rate bonds less attractive. As inflation expectations rise, investors typically demand higher yields to compensate.
Central banks often choose to raise interest rates to fight inflation, and bond markets tend to anticipate and price in expected policy changes before they occur.
Anyone worried about this situation might look at inflation-linked bonds. The coupon they pay rises and falls with inflation, helping to protect your purchasing power. The downside is that inflation-linked bonds often come with lower initial yields than conventional bonds. If inflation is lower than expected, these types of bonds can underperform traditional fixed-rate bonds.
Dan Coatsworth: Head of Markets
Dan Coatsworth is AJ Bell's Head of Markets. Dan has been with the company since December 2012 and has more than 18 years' experience in the industry, following the markets and all things investing. He...
