What are Bonds?

What are Bonds?





A brief history

Since the 1970s and 80s bonds were considered boring.  Many saw them as guaranteed losers.

Many investors looked to what they thought to be sensible investments, and during this time these were equities.  Shares in the quoted companies had made real gains even after the high inflation for much of the time period.

Even small shares in boring companies could earn their keep. The fund-managers, who controlled more of the stock market during the second half of the twentieth century, had bought shares with their members’ money while their counterparts in the United States and Europe continued to buy bonds, however  their performance couldn’t compare with that of UK management firms.

However those in the pension funds got older and the amount of new employees joining the funds fell dramatically as scheme after scheme was closed to new entrants.  The Fund managers no longer had to deal with a younger crowd who didn’t worry a lot about pensions, but a large number of retired or almost retired folks.  It was their customers who needed the secure pension payments each month. And the only way they could get those monthly payments with some security was through bonds.

Even if you no interest of buying any bonds, it’s still good to know about them as their prices can determine other parts of the financial market.

 So a Bond

A bond is one of the words within the financial services industry that gets used all over the place. Many of the Industry folks like it because it inspires confidence.  At a basic level a bond is basically a loan made by investors to a company, national government or international body. And in return, the company, government or international body offers to pay the holder a fixed amount of interest on a set date over a period of time and promises to repay a pre-established amount on a set date in the future, so because of this, bonds are often referred to as fixed-income investments.

To many investors cash is widely considered to be the lowest-risk investment around. While bonds are one investment step- up from cash in an established bank. However the returns are a slightly higher, but all investors have to take a little bit more risk for the privilege.

For many investors, bonds have one big difference over the bank style loan. Bonds are traded on many stock markets.

The cost to issuers, such as governments or companies, doesn’t change during the entire bond’s life the value to the holder of the bond can be changing all the time. The price goes up and down with the economic cycle and interest rates. But the amount the bond issuer has to pay when the bond reaches its maturity, date doesn’t change.

If a bond certificate says the amount is £50,000 then £50,000 is what the bond holder gets back on maturity, regardless of the price that investor paid at the time of purchase.

Difference between Bonds and Shares

Many Companies who need to raise cash can issue shares (also known as equities). They can also issue bonds (these are called corporate bonds to make it be known that they are different from bonds issued by governments) and get the same amount.

bonds

So what’s the difference?

  • Share can be very volatile in price.
  • Bond prices are often more stable from day to day.
  • Shareholders are the legal owners of the company, and get to attend an annual general meeting and can quiz members of the board. So company shares give holders a say in the company proportional to their holding.
  • Bondholders have to worry more about credit risk – this is the chance that a company will perform badly that it’ll default on loan repayment or on an interest payment.
  • Shares pay dividends, which can go down as well as up. Sometimes companies can decide to miss dividend payments altogether. The rate of dividend depends on the profits the company has made .
  • Bondholders, in the majority of cases have no ownership or voting rights.
  • Bonds pay interest (known as the coupon). This interest is fixed whether the company is doing well or not however bond interest must be paid before any share dividends can be issued.

UK Government Gilt

Gilts are UK government bonds. They’re known as gilts or gilt-edged because the certificates used to have gold coloured borders.  Gilts are one of the ways the UK government pays for its spending other than raising taxes (which is not popular with the voters).

Investors don’t have to worry about the government going bust, if the UK government ever fails to pay its legal obligations, there’ll be a lot more problems!

Gilt also appeal to cautious UK investors because they’re in GBP sterling.

A redemption date is the final date after which the gilt will have to be repaid. The date is typically 5 to 30 or even 50 years in the future.

Gilts can go up and down in value. Government bonds react to interest rates so if a bond has only a few months until redemption, there’s isn’t much chance of an interest-rate change. However this can be different if the bond has 20 years to go, then anything can happen.

bonds

What Makes the Price of a Bond Go Up and Down

If an investor puts £5,000 savings in the bank the money stays at £5,000. What the investor generally doesn’t know is how much interest the investor will get.

Put the same money into a gilt or other government or a company bond , and the £5,000 could be worth more or less the next day. But the interest will be known. With a bond, the interest is fixed, but the capital value is variable.

Like everything in the stock markets, bond prices are driven by supply and demand. When people want to buy, the price rises and when people want to sell, the price falls.

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