How to invest in bonds
Bonds are an important part of any well-diversified investment portfolio. But how to invest in bonds? It can appear daunting – should you select sovereign bonds, corporate bonds, or a mixture of both? Read on to find out more about bond investments.
Bonds were once viewed as an old-fashioned investment instrument, delivering minimal returns to conservative investors who had no confidence in the stock market. That was before the one-two punch of the global financial crisis and the Brexit-related weakness in UK stocks. Today, stock market volatility is still keeping conservative investors at bay, while Cash ISAs and bank-based savings accounts are unable to keep up with the rate of inflation.
Inevitably, bonds have come back into fashion again. According to recent Moneyfacts data, the average bond returns reached a two-year high in April 2018, and strategic bonds have been topping the investment charts since the middle of 2017.
Clearly there is an appetite for fixed-term returns in the current economic climate. But does that make bonds a good investment?
What is an investment bond?
Bonds have been around since 1694, when the Bank of England (BoE) needed to raise funds to pay for a war with France. More than 300 year later, many people still ask: what is bond investment?
In its purest form, a bond is a loan that has been issued by either a government or a corporation as a way of bringing in new funding. Investors buy into the loan and in return they receive a regular amount of interest (usually paid either monthly or quarterly) for the duration of the bond. Once the bond has reached the end of its investment period, the capital is returned to its investors.
Bonds can last anywhere from three months to 20 years or more, although the average government-backed bond tends to be offered on a two-year, five-year or ten-year basis. The bond market can appear full of jargon, but it’s relatively easy to get to grips with the key terms: a Treasury is a sovereign bond issued by the US government, a gilt is one issued by the British government and a bund is one issued by the German government, for example.
Returns on bonds can also vary, and they will generally be higher or lower depending on the nature of the loan, and the reliability of the issuer. For instance, the UK government is considered to be a relatively safe issuer, so government bonds are usually offered at less than 2% per year. In contrast, a listed company with a poor track record may need to offer up to 10% in annual returns, in order to attract wary investors.
As with any loan-based investment, the major risk is that the company or government may not be able to pay you back the bond capital you invested at the end of the loan term. For this reason, it is always worth checking the risk status of a newly-issued bond via a credit rating company such as Standard & Poor’s (S&P's) or Moody’s before parting with any money.
Over the years, bond investing has become more complex, and investors can now put their money into a range of different bond instruments. Bond-based exchange traded funds (ETFs), for instance, allow investors to track a number of different bond indexes, so one small investment is effectively diversified across a number of different bonds.
Find bond ETFs using IG’s ETF screener
Why invest in bonds?
Newcomers to the bond sector tend to have a lot of questions: are bonds a safer investment than stocks? How many bonds should I buy? And what sort of returns can I expect to receive?
As with any investment, there are no guarantees when it comes to bonds. No matter how secure a bond appears to be, there is always a risk that the issuer will not be able to make any interest payments, or to repay the capital. However, these risks can be minimised by choosing security-backed bonds from issuers who have a strong track record, and by checking the credit rating of each bond before investing.
Actual default rates are very low, so the vast majority of investors will receive the returns that were promised to them from the outset. For this reason, bonds are often seen as safer than stock market investments, where volatility can occur on a daily basis driving down the value of shares and making it difficult to calculate regular returns.
Many bond investors find that by spreading their money across several similarly-priced bonds they can offset any potential defaults or losses. Bond ETFs offer instant diversification at low fees, and they have become increasingly popular with income-seeking investors who are unwilling to take on any additional risk.
Returns can vary depending on the sort of bond or ETF that you are investing in. For instance, between May 2017 and May 2018, the Lyxor iBoxx Liquid Corporates Long Dated UCITS ETF returned more than 8% for investors. By comparison, the iShares Index-Linked Gilts UCITS ETF returned just 1.49%. So what’s the difference between these two bond ETFs? The answer is that one invests in higher-risk corporate bonds, while the other focuses on lower-risk government bonds.
Ultimately, the best bonds to invest in will offer regular (and ideally inflation-beating) returns with a low risk profile and a credit rating of A or above from a reputable ratings agent. By creating a diversified portfolio of bonds — e.g. bond funds and bond-focused ETFs — investors can further minimise their risk while still benefiting from growth within the sector.
Read more about what bonds actually do in your portfolio
When is the best time to invest in bonds?
There is no perfect time to invest in bonds. Corporate bonds and government bonds are issued every day, although the highest paying government bonds tend to sell out quickly.
To avoid disappointment, it is best to invest in a government bond on the day that it is released. Investors can put their money into bond funds and ETFs at any given time.
However, if you are holding your bond investment within an ISA tax wrapper or self-invested personal pension (SIPP) portfolio, you can maximise your returns by investing as early in the tax year as possible.
Investment bond taxation states that all investment bonds should be taxed at 20%, although investors can withdraw up to 5% per year tax free. This 5% can be rolled over for one year. By choosing an ISA-eligible bond investment, you can avoid these charges, reinvest your interest payments, and watch your money grow over time.