Investing in bonds

Bonds are debt securities issued by governments and businesses around the world, often popular with investors due to their low risk level. There are several different types, so continue reading to learn more about the bond market, including the benefits and risks involved, and how you can buy and sell bonds.

What are bonds?

A bond is a type of fixed-income or fixed-instrument investment. When you invest in a bond, you effectively lend money to a company or government until a specified date – known as the maturity or redemption date. The company or government are the ‘issuer’ of your bond.

Bonds can be bought by individual investors, as well as by large institutions such as banks, pension funds and insurance companies.

How do bonds work?

When first issued, bonds are sold to investors via a broker or investment house. Gilts can be sold directly to the public through the UK Government Debt Management Office (DMO).

In return for buying the bond, you’ll receive an interest payment from the issuer known as a coupon. This is usually paid once or twice a year, depending on the type of bond. At the end of a set period when it reaches maturity, you’ll get back the face value of the bond, also known as the ‘par’ value – unless there’s a default.

Or if you prefer, you can choose to sell your bond to another investor before the maturity date via an investment platform like AJ Bell. You’ll get the current market price for it, which will be different to the face value of the bond.

Keep in mind that corporate or government bonds aren’t the same as fixed-term accounts or cash savings bonds offered by banks and building societies.

Types of bonds

Why do people invest in bonds?

There are two main reasons:

1. Investors seeking income can buy bonds to plan a predictable stream of cash over time.
2. Other investors may look to sell bonds on the secondary market to make a profit.

Most bonds available to retail investors fall under the category of ‘fixed interest bonds’, meaning they pay a fixed rate of coupons each year. Knowing what you will receive throughout the lifespan of the bond can be helpful if you are working out how to pay for items such as school fees.

Investing in bonds is generally considered safer than investing in individual shares. Bonds are lower risk than shares but are not completely risk-free.

As long as the issuer remains solvent, the bond holder should continue to receive their regular coupon over time – as well as the principle when the bond matures. In contrast, although a shareholder owns a part of a company, future dividends from shares depend on the profits and investment strategy of the company and could be reduced or cut altogether.

Investing via a fund

If you're interested in the idea of bonds, but don’t want to have to pick individual ones, you could invest in a specialist bond fund or exchange-traded fund (ETF) instead.

There are different types of bond funds and bond ETFs including those that invest specifically in gilts or a broader range of government bonds from around the world. A strategic bond fund is one that has the flexibility to invest in any parts of the market, be it bonds issued by governments or corporate businesses.

Actively managed funds involve a fund manager making all decisions as to which bonds to buy or sell in the portfolio. In contrast, a passive fund, such as an ETF or tracker fund, won’t use a fund manager. Instead, they’re designed to mirror the performance of a specific index which is made up of bonds that meet certain criteria.

What tax do you pay on bonds?

Gilts and most UK corporate bonds are free from capital gains tax. The income you receive from bonds is paid gross but will be subject to tax depending on your other income.

These investments won’t be subject to income tax if you hold the bond in a tax-wrapper account like an ISA or a SIPP. You can usually hold bonds listed on a recognised stock exchange in these accounts.

Just keep in mind that tax rules can change and will also depend on your personal circumstances.

How do interest rates affect bonds?

Central banks set an official interest rate for their country and this acts as a benchmark for interest rates offered by banks and building societies. When interest rates go up, bond prices typically fall and yields rise, and vice-versa.

Investors often require a particular level of return and their decisions can be heavily influenced by the general rate of interest.

If interest rates rise, investors’ required rate of return also rises. In this situation, they may want to pay less for a bond already in issue, preferring newer bonds with higher yields. This can lead to investors selling existing bonds when interest rates go up and this action pushes down bond prices.

If interest rates fall, investors may be prepared to pay more for a fixed-rate bond than previously, and bond prices may rise.