Bonds are securities representing the debt of a government, company or other organisation. Effectively they are loan stock, or "IOUs" issued by these organisations and bought by investors such as banks, insurance companies and fund managers.
Investors are often heard to say "I don't understand bonds", but the truth is that these instruments are much simpler than equities. The key factors can be broken down as follows:
- The issuer: This is the entity which is borrowing the money. For instance, £500 million will be borrowed, and £500 million of securities will be issued. Typically these will be sold at "par" or 100p in the pound
- The coupon: The issuer commits to pay a rate of interest of "X" % per year. This coupon will generally be a fixed amount and is paid annually or semi-annually.
- The maturity: A date is set for the repayment of the money. This is known as the redemption date. The bonds will be redeemed at "par" or 100p in the pound (with some rare exceptions)
At launch, bonds are sold to investors via an investment bank or broker. This is known as the primary market. Gilt issues are also offered directly to the general public. After this primary phase, bonds are then free to trade between investors and/or market counterparties. However, unlike equities that trade through a centralised stock exchange, bonds generally trade on a peer-to-peer basis from one institution (such as an investment bank) to another (such as broker).
This global market in bonds is enormous. Figures released by the International Monetary Authority in 2002 estimated the total amount of debt securities as around 43 trillion US Dollars. At the time this was nearly twice the total of the world's stock market capitalisation. The number of bonds in circulation is considerable, and a large and regular issuer such as the European Investment Bank may have several hundred issues trading at any one time. These bonds will be issued in a variety of currencies and may differ greatly from each other in terms of coupon or coupon type, date of maturity and other features such as imbedded puts and call.
This website is aimed at Sterling-based investors, and thus deals primarily in GBP-denominated bonds. With this in mind we monitor a restricted "universe" of around 200-300 bonds selected on the grounds of liquidity and ease-of dealing for the private investor. Our focus is also towards "investment grade" bonds, ie those with higher credit ratings which are likely to offer a lower risk profile.
The table below provides further information about the various types of bonds on this website.
Gilts or UK Government bonds: these are bonds issued by the UK government in order to finance public spending. UK Gilts are rated AAA by all the major credit ratings agencies and can be viewed as effectively risk-free from the point of view of default. The price of these instruments will fluctate from day-to-day in the market, depending on the outlook for interest rates but investors who buy at par or below, and hold the bonds to maturity can be certain that interest and principal will be repaid in full.
Conventional Gilts: The majority of Gilts are of a conventional nature, paying a fixed coupon (generally twice a year) and maturing at a set date. The life of these instruments will vary from a few months out to as much as fifty years. The most popular Gilts for private investors are maturities between two and ten years. Some gilts have more complex features such as "calls", which enable the government to retire the debt ahead of time. Before purchasing a Gilt, it is worth checking the full details of the issue. Please note, prospectus for Gilt issues can be obtained at the website of the government Debt Management Office.
Index-linked Gilts: These instruments were first issued in 1981. Rather than pay a fixed coupon and amount on redemption Index-linked gilts differ from conventional gilts in that the semi-annual coupon payments and the principal are indexed to the UK Retail Prices Index (RPI). It is worth noting that there is a time lag on the RPI used to calculate the coupon and redemption period, however these instruments do offer a hedge against inflation.
Because of the inflation-linking aspect of these bonds, Index Linked Gilts may show wider movement of price over time.
Undated or perpetual Gilts. These instruments differ from convenentional Gilts as they have no set maturity date. They may (or may not!) be paid back at a time of the government's choosing. Because of this the holder is reliant on the market price to liquidate his investment, and as such they should be viewed as more risky than conventional Gilts. The most well known amongst this group is the UK 3.5% War Loan.
These instruments are more volatile than conventional Gilts (which inevitably trend towards par).
Sterling denominated non-Gilt: These are the biggest group of bonds on this website, and covers the majority of GBP-denominated bonds other than UK Gilts. These securities are often known as corporate bonds, although they may be issued a range of types of organisations, not all of whom are strictly "corporations".
These bonds may be issued by a variety of different types of issuers, ranging from foreign governments and their agencies, through UK Banks and all the way down to medium-sized companies. As with Gilts, the prices of these bonds will move alongside the market's expectations for interest rates. However, the price (and thus the yield) will also be affected by the perception of the credit quality of the issuer. If this is thought to be deteriorating, the price of the bond will fall.
The best way to determine the relative value of a bond is to compare the "spread" or incremental yield offered over a Gilt of the same maturity. The investor will then be comparing "like with like" and a value judgement can be made regarding the balance of risk to any additional reward. Thus, at the time of writing, five-year Gilts offer a yield of 2.9%. The Segro 6.25% Sept 2015 bond offers 4.9%, a "spread" of 2% (also known as 200 basis points) over the Gilt. This should then be compared to other bonds of similar maturities.
PIBS: or Permanent Interest Bearing Shares: These are a type of instrument issued by UK building societies. Technically they are not bonds, but a type of risk capital, being subordinated to deposits and other senior obligations of the society. The events of 2009 demonstrated that this subordination is a real risk for investors and holders of PIBS in many building societies and ex-building societies have been adversely effected.
Because of their fixed coupons. PIBS behave in a manner similar to bonds and offer investors a long-term income stream and these securities remain popular with private investors.
Individual issues vary greatly in coupon, price, yield and other features such as calls.
Other types of bonds
Floating rate notes: These are bonds where the coupon is not fixed, but based on a reference rate, typically LIBOR. They do not exhibit the same degree of interest rate sensitivity as conventional bonds. The majority of FRNs will be issued with maturities between two and ten years and will be senior debt. However, there is a class of perpetual floating rate notes which you may encounter from time time. The majority of these are subordinated debt.
Convertible bonds: These are bonds where the holder may convert his redemption proceeds into the equity of the issuing company. These are known as "equity convertibles" and can offer a combination of yield and growth for investors. These instruments may see their price driven higher by a rise in the company's equity. Risk, however, is generally higher.
In some cases, bonds may be issued with the option to convert into other bonds. These are a rather different kettle of fish and should not be confused with the "equity convertibles" above.
Subordinated bonds: The majority of bonds issued are "senior debt", meaning that the holder has a priority claim on the company's assets, ahead of that of the shareholders. Some bonds are issued with "subordinated" status. This means that the buyer of the bonds accepts a lower claim on the company's assets, below the senior debt holders, but above the equity holders. Because of the additional risk, a higher yield will be offered. These bonds are also more volatile and show greater sensitivity to shifts in the perceived credit quality of the issuer.