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Bonds usually appeal to investors seeking an income stream and a certain level of capital protection. Traditionally viewed as ‘safer’ than equities while offering better returns than a cash account, bonds typically form part of a diversified, long-term portfolio. How big a part will depend on your attitude to risk and personal views on the asset class.
If you want to buy bonds, you may find the easiest way to do so is through a bond fund. Your money gets combined with lots of other people’s so it can be spread across a range of bonds. What’s more, you get professionals thoroughly researching the investments for you, which is good, because bonds can be pretty complicated.
Governments and companies issue bonds as a way of borrowing money. When you buy a bond, you are effectively lending money. Just like that government or company would pay interest on a loan if they borrowed from a bank, they instead give you a regular interest payment. After a period of time, they should also pay back your original amount.
There are three bond terms you should know:
So far so good, right? Things get more interesting. Once a bond has been issued, the original buyer does not have to keep it. They may sell it on a ‘secondary market’, where it can then be traded just like a company’s shares.
This means that bond prices can go up and down and you might not end up getting back the original amount you invest. And although the coupon rate is set when the bond is issued, the level of income you actually receive may vary. This is where the skill of a bond fund manager comes into play, as the good ones will analyse a range of factors to determine the outlook for each and every bond in which they invest.
The four main influences on bond prices are:
Bonds are normally graded according to their issuers’ ability to repay their debt – i.e. their credit worthiness. Ratings agencies such as Standard & Poor’s and Moody’s use letters ranging from AAA (the highest quality) to CCC or D (the lowest quality), to provide this information to investors.
A company or government with a high credit rating is considered to be ‘investment grade’. Because the risk of losing money on these types of bonds is lower, you’re probably likely to get less interest too. These bonds will typically include those issued by developed market governments and big, stable corporations.
The bonds issued by a company or government with a low credit rating are referred to as ‘high yield’ or ‘junk’ bonds. Because the issuer has a higher risk of failing to repay their loan, you should receive a higher rate of interest as a trade-off for taking that risk. These bonds will usually include those issued by emerging market governments and potentially by smaller firms or firms whose credit rating has been downgraded due to a poor profit outlook.
We’ve Elite Rated a range of bond funds to help you to invest. These are sometimes also referred to in the industry as ‘fixed interest’ or ‘fixed income’ funds.
We rate only a handful of funds, which we believe to be the ‘best of breed’, across the Investment Association’s bond sectors: