How to invest in bonds and gilts
We explain the practicalities of investing in bonds and gilts, and the risks and benefits for all types of investors at any stage of investment.
The value of your investments may go down as well as up. You may not get back all the money that you invest. If you are unsure about the suitability of an investment product or service, you should seek advice from an authorised financial advisor.
Why invest in bonds?
Bonds are an attractive investment for income-seeking investors. They pay interest, known as the coupon, for a fixed period of time. Providing that the institution does not go bankrupt, the buyer of the bond is paid interest and receives their capital back at the end of the term.
Bond coupons are more reliable than the dividends promised by companies, which can be suspended, cut or cancelled at any time. This is what happened during the early stages of the Covid-19 pandemic, when scores of companies took an axe to their dividends.
The bonds asset class has proven its worth as a protector of capital over the long term because it is uncorrelated with the performance of stock markets. The diversification benefits of holding bonds alongside shares has historically helped cushion investors from sharp falls in stock markets.
Is now a good time to invest in bonds?
For a number of years, bond yields were at very low levels due to low interest rates. This was also caused by quantitative easing, or QE, which is when central banks purchase bonds.
The bond market in 2022
This has changed in 2022. Bond yields have risen to their most attractive levels in several years, and bond prices have fallen sharply, due to soaring inflation and higher interest rates.
The fixed income which bonds pay becomes less valuable when inflation rises. At the same time, bonds become less attractive when interest rates increase because there is greater competition from returns on cash and better deals available from newly issued bonds.
Because there is less of an incentive to buy bonds, this results in bond prices falling. As bond prices and bond yields have an inverse relationship, yields rise whenever prices fall.
Yields have risen sharply, meaning investors can now pick up the highest level of income on offer in a long time.
Investors need to consider inflation and the direction of interest rates. If inflation is high, and interest rates rise, then bond prices will fall. This will cause bond yields to rise further.
What types of bonds can I invest in?
There are two main types of bond - corporate bonds issued by companies, and government bonds issued by governments.
Government bonds issued by the UK government are also called gilts. American government bonds are known as Treasuries, or T-bills.
Most government bonds pay a fixed rate of interest, but can also be index-linked, meaning that coupon payments rise and fall with the rate of inflation. About a quarter of UK government bonds are index-linked.
How to invest in bonds with ii
Investors can buy individual bonds through interactive investor, at ii.co.uk/bonds . There are plenty available on the platform, from UK or US government bonds to those issued by big companies such as Aviva or the Co-Op.
How do I decide what bonds are right for my portfolio?
UK and US government bonds are at the safest end of the risk spectrum due to the low risk of those governments not being able to service their debt. The highest risk bonds are high yield bonds and emerging market bonds, in which there is greater uncertainty.
Strategic bond funds can mix and match any type of bond, such as government bonds, investment-grade corporate bonds and high-yield bonds. The professionals running these funds can steer their portfolios to the best bonds to profit from the macroeconomic backdrop. Funds in this sector also have the ability to select the best bonds to protect and profit from interest rate rises.
Other bond funds are more constrained in that they can invest only in a specific part of the bond market.
In order to achieve diversification, most investors prefer to outsource the decision making to an actively managed bond fund. This is either run by a fund manager who builds a portfolio of bonds, or an index fund or exchange-traded funds (ETFs) that takes a passive approach and simply tracks an entire bond market. Index funds and ETFs are passive strategies, as they aim to closely match the return of an index.
Do bond yields suggest how attractive a bond is?
Generally speaking, the higher the bond yield the higher the risk. As a result, bond funds that invest in the riskiest bonds such as high yield bond funds and emerging market bond funds offer the highest yields. Bond funds that invest in the safest part of the bond market, typically UK and US government bonds, have the lowest yields.
As bond prices and bond yields have an inverse relationship, rising bond yields reflect a falling bond price, and vice versa.
How can investors make money by investing in bonds?
Investors can buy bonds directly and hold them until they mature. Bonds can also be bought or sold above or below their issue price or face value after they’ve been issued on the secondary market. Depending on the price paid, a profit or loss will be made on the amount invested. While waiting for the bond to mature investors are paid interest at a fixed rate, known as the coupon, typically twice a year.
Bond funds aim to provide a return for investors from a combination of income and capital growth.
Income is paid either monthly, quarterly, twice a year or once a year. With bond funds, investors can buy and sell anytime they wish, as funds offer daily dealing. Five years is generally considered a minimum time period to invest in bond funds in order to ride out any market turbulence.
Over the years bonds have proven their worth as a defensive asset in a diversified portfolio to complement shares, which offer the prospect of greater growth but are more volatile.
Tips and best practice when investing in bonds
There are a number of key considerations when assessing a bond, but the main ones are:
- - time
- - the interest on offer
- - the issuer
- - the economic environment including the direction of interest rates and inflation expectations.
Time considerations when buying bonds
Bonds with a short lifespan are impacted less by increases in interest rates compared to bonds with longer maturities.
The most important metric to look at is duration, which will be shown on a bond fund factsheet. Duration measures the sensitivity of individual bonds to changes in interest rates.
As with any investment, it is important to consider your investment objectives, such as how long you are planning to invest for, and how much risk you are prepared to take. You must also understand your tolerance to risk rather than appetite for reward.
The bond duration vs interest rates calculation
For every 1% rise in interest rates, a bond’s price will typically fall by about 1% for every year of “duration”.
The longer a bond’s duration, the higher the yield an investor would expect in order to compensate for the greater risk involved.
Age considerations when buying bonds
When you’re at the start of your retirement saving journey in your twenties or thirties it makes sense to invest most of your pension in shares. While riskier than bonds, historically shares offer higher rewards over the long term.
When approaching retirement you should consider increasing exposure to defensive investments, which is the role of bonds in a portfolio as a protector of capital. People who leave their entire portfolio in shares close to retirement face the risk that a steep stock market decline might occur when there is little or no time for the investments to recover in value.
In retirement, the interest that bonds pay can also help to provide a steady and predictable income.