Choosing an Asset – Understanding Bonds

Bonds are the most-traded kind of asset in the world, by a country mile. You’ll also hear them called fixed interest or fixed income investments, and sometimes they’re just called ‘paper’ which is a bit weird.

Essentially a bond is an IOU. If a company or a country needs to raise money it may issue a bond. You as the investor buy the bond and in doing so you are lending your money to the issuer.

Let’s say it’s Marks & Spencer. M&S might use your money for cashflow or to open a new store or whatever. What they do with it doesn’t really matter, it’s what you get out of it as the investor that we’re interested in. You will get a fixed income, called the coupon, for a finite period of time, until the redemption date, at which point you’ll get your money back – exactly what you invested.

So far, so simple, but these IOUs are traded on the stock market, so if you bought an M&S bond for £100, you could sell it on the stock market for £110 and make a profit. At that point, the person you have sold the bond to becomes the lender to M&S, they get the income and they get £100 back at the redemption date.

Why would anyone buy something which they know they are going to lose money on? Well it might be that they’re after the income primarily, perhaps because they want to buy a known, regular income to pay a member of a pension scheme or some other reason.

Bonds really are about the income primarily. They tend to be less volatile than shares, in that their capital value tends to go up and down less severely than shares, but that’s a massive oversimplification.

Like most asset classes, bonds come in many different flavours. Lending money via a bond to my little company Jacksons Wealth Management is a much riskier deal than lending money to the UK Government via a special kind of bond called a Gilt.

Long-term bonds behave differently to short-term ones. Bonds issued by companies in Argentina or some other emerging economy are likely to be much riskier than a similar bond issued by a company in Germany.

Most usually, bonds are used in a portfolio of investments to temper the risk of equities. The risk that you might lose money investing in bonds is mitigated to some extent by the income they can produce.

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