Understanding the Bond Market: What is a Bond?

We walk you through the process of investing in assets with lower levels of risk, such as corporate bonds, government bonds, and gilts.

What exactly is a bond?

Bond investing can be seen of as a form of short-term loan of money to various entities, such as corporations or governments. Gilts are the United Kingdom’s Treasury bonds.

In exchange, you will receive a regular income from them in the form of interest payments for a predetermined amount of time, after which they will be required to repay the loan.

Bonds are commonly referred to as fixed-income investments since repayments have historically been set at a predetermined amount; however, bond rates can also be flexible.

This article will explain how bonds operate, the kinds of returns they may provide you, the kinds of dangers you may face, how to invest, and what function fixed income assets may play in your investing portfolio if you choose to invest in them.

Why would you put your money into gilts, corporate bonds, or government bonds?

You will need to be willing to take on more risk if you want to earn a return that is superior to the one you can obtain on your cash savings.

Fixed-income investments are typically regarded as the next level of investment after cash and typically carry a lower level of risk than share investments.

They are intended to provide you with a consistent income and do not typically provide prospects for capital growth – at least, not in periods when the economy is operating normally. The following are the most prevalent types of investments in fixed income:

Corporate bonds

Gilts

When the government of the United Kingdom needs to raise money, it turns to the issuance of these fixed-income instruments.

When you purchase gilts, you are essentially lending money to the government in exchange for a regular interest payment (sometimes referred to as the “coupon”) for a predetermined period of time.

The coupon is established at the time the gilt is issued, and its value is based on the amount of time that must pass before the gilt may be cashed in. Because you will have to wait longer to be returned, the interest rate you earn will be higher as the date of redemption gets further and further away from you.

In the same way as cash savings are susceptible to the impacts of inflation, gilts that pay a set rate of interest are as well. On the other hand, the coupon on index-linked gilts is calculated based on the retail price index (RPI) that was released three months earlier.

Gilts are widely seen as investments with a very low level of risk due to the widespread belief that it is extremely unlikely that the British government will declare bankruptcy and, as a result, be unable to pay the interest that is due or return the loan in its whole.

Other forms of government-issued bonds

In addition, national governments around the world will sometimes offer bonds to the public in order to collect funds. On the other hand, these are sometimes associated with a higher risk.

The crisis that started in 2009 in the Eurozone proved that some countries prove to be safer investments than others. Anyone who owned Greek government bonds before the crisis will have found out what happened to their investment as a result of the crisis.

Bonds issued by companies

Companies that are interested in increasing their capital may choose to issue corporate bonds.

They are thought to be riskier than gilts since it is widely believed that businesses have a greater likelihood of defaulting on their debt than stable governments. Because of the greater potential for loss, investors in corporate bonds typically receive a higher rate of interest.

shares that accrue interest continuously and permanently (Pibs)

Pibs are similar to corporate bonds; however, building societies are the primary issuers of pibs. Building societies that have demutualized their operations will sometimes issue perpetual subordinated bonds.

How exactly do corporate bonds and gilts function?

A traditional gilt from the UK might look something like this:

Treasury stock at a rate of 3% in 2030

The following is an explanation of the various components:

The coupon rate is 3% of the purchase price. This number represents how much you can expect to receive each year, with payments typically made on a semiannual basis.
Who you’re lending money to when you buy Treasury shares. If you are interested in corporate bonds, you can discover the company’s name here, such as “Tesco PLC 4%.” 2018.
The redemption date is 2030, which is also the day on which you will get the principle (your initial investment).
The yields generated by gilts and corporate bonds

If you take out a loan of 1,000 pounds and invest that money in Treasury stock with a yield of three percent until 2020, you will receive an annual interest payment of thirty pounds, or three percent, until the loan is returned. Your income is referred to as the ‘income yield,’ the ‘running yield,’ or the ‘interest yield,’ and it is given to you twice yearly (1.5% of the principal or £15 every six months in this scenario).

The length of time you have to wait until the coupon matures and/or the level of risk associated with the company in which you invest will influence the amount of the coupon.

Because you would have to wait longer to be repaid, the interest rate that you will earn will be higher as the redemption date gets farther and further away. In a similar vein, the bigger the level of risk you take on a company, the higher the interest rate you can anticipate receiving in return for your investment.

Bonds issued by corporations and gilts that are traded on the secondary market

However, the majority of gilts, government bonds, and corporate bonds are sold on a secondary market, and the value of these bonds can fluctuate depending on interest rates and the financial stability of the issuer. Gilts can be purchased at issue from the government’s Debt Management Office.

Bond prices will increase when general interest rates are low because the interest rates that bonds pay are set and will be higher than the short-term rates that are available from banks. This will lead bond prices to rise.

Because of this, it is possible to purchase a bond or gilt for an amount that is either higher than or lower than the nominal value; however, doing so will have an effect not only on the amount of interest you receive as an income but also on the total sum of money you will receive when the bond matures.

The process goes as follows:

Secondary market

If, for instance, you paid £95 for a gilt, government bond, or corporate bond with a nominal value of £100, you would realise a capital gain when it matures since the loan is repaid at the nominal value. This is the case regardless of whether the bond was issued by a government or a corporation.
In the same vein, if you purchased the gilt, government bond, or corporate bond for the price of £105, you would incur a loss upon maturity because you are only reimbursed the bond’s nominal value.
The amount of money you put into the investment will also have an effect on how much interest you get back on it. If you acquire a bond or gilt with a coupon rate of 6% for a price of say £95, the effective interest rate you’ll receive will be higher than 6% because interest is paid on the nominal value of the investment and not the second-hand market price at which you purchased it.
In this particular scenario, the rate that you are offered is actually 6.32 percent (that is, 6 percent multiplied by £95 yields 6.32 percent).
What exactly is meant by the term’redemption yield’ when referring to a gilt or a corporate bond?

The redemption yield is a rate of return that is calculated by adding together two different rates of return: the interest rate that you receive based on the price at which you buy the gilt, government bond, or corporate bond, and the profit or loss that you receive if you hold the bond until it matures.

If you purchased a gilt, government bond, or corporate bond at a price that was less than the launch price (£100), the redemption yield will be higher than the running yield because you will be in a position to make a profit when the bond matures. This is because the redemption yield takes into account the fact that you will have paid less than the launch price.

On the other hand, if you buy a gilt, government bond, or corporate bond at a price that is higher than the launch price (£100), the redemption yield will be lower than the running yield because you will incur a loss if you hold the bond until it matures. This is because the redemption price is based on the assumption that you will hold the bond until it matures.

Green gilts and green corporate bonds

The operation of green bonds is identical to that of any other type of business or government bond.

In practise, it would be necessary for the funds that would be obtained through green bonds to be allocated to the development of renewable energy and other clean energy projects.

In September 2021 the UK began issuing Sovereign Green Bonds (or ‘Green Gilts’).

What are the credit ratings of corporate bonds and gilts, and how do they compare?

Credit ratings are assigned to financial instruments such as Gilts, government bonds, and corporate bonds by organisations such as Standard and Poor’s and Moody’s.

Investment-grade bonds

Gilts, government bonds, and mostly corporate bonds with a high rating (anything from AAA down to BBB) are considered to be ‘investment-grade,’ which means they have a lower risk than other types of bonds.

On the business side, these ratings are typically bestowed upon entities that can demonstrate a strong financial position, such as grocery stores and utility corporations.

Bonds with a high yield

Companies who are regarded to be at a greater risk of being unable to pay back their debt (also known as “defaulting”) will be the ones to issue “high-yield” bonds, which are also occasionally known as “junk bonds.”

They provide significantly higher rates of interest in the hopes of luring investors willing to take on further risk. These businesses will have a grade of BB or lower at the very least.

Credit ratings for gilts, government bonds, and corporate bonds respectively

This table presents the ratings given by Standard and Poor’s to gilts, government bonds, and corporate bonds, as well as the information that may be gleaned about the financial state of a specific firm or government bond based on those ratings.