For private investors, understanding how the bond market works and why bonds matter is essential to promoting better long-term outcomes for our wealth journey.

Bonds are a cornerstone of investing and can unlock opportunities to diversify portfolios, manage risk and generate steady income. But there are important aspects of bonds to be aware of too.

This article explains what bonds are, how the bond market works and why it is relevant to private investors. 

What are bonds

Bonds are financial instruments issued by borrowers, typically governments or businesses to raise funds. 

When you buy a bond, you are lending your money to the borrower in exchange for regular percentage-based interest payments, known in the industry as a ‘coupon’ or a ‘yield’. The cash invested in the bond is returned when it reaches ‘maturity’. 

Bonds are often referred to as ‘fixed-income securities’ because they generate a predictable stream of interest payments over time.

There are several types of bonds, each with unique characteristics. Government bonds, such as U.S. Treasury bonds or UK ‘gilts’, are considered lower risk because they are backed by a government. 

Corporate bonds, issued by companies, carry higher risk but often offer higher yields too. There are categories within this too, such as ‘investment-grade’ and ‘high yield’. These tend to reflect the relative risk of the corporate bond in question. 

Understanding these distinctions can help investors choose bonds that align with their risk tolerance and financial goals.

Bonds have key features that influence their value. The yield determines the interest paid, while the maturity date indicates when the initial investment is repaid. Bonds also have a ‘face value’, which is the amount returned at maturity. 

Market conditions such as interest rates and economic trends affect bond prices, making it essential to understand how these factors interplay.

How the bond market works

The bond market, sometimes called the debt market or fixed-income market, is where bonds are issued, bought, and sold. It is one of the largest financial markets globally, with trillions of dollars in bonds traded daily. 

Unlike the stock market, which operates through centralised exchanges such as the London Stock Exchange, the bond market is primarily an ‘over the counter’ market. This means transactions occur directly between buyers and sellers, often aided by brokers or dealers.

The bond market has two main segments: the primary market and the secondary market. 

In the primary market, new bonds are issued and sold to investors. For example, a corporation may issue bonds to finance a new project and investors purchase them directly from the issuer. 

Once issued, bonds trade in the secondary market, where investors buy and sell existing bonds. 

The secondary market provides liquidity, allowing investors to adjust their portfolios as needed. Bond prices in the secondary market fluctuate based on supply and demand, interest rates, and the issuer’s creditworthiness. 

A key concept is the inverse relationship between bond prices and interest rates. When interest rates rise, existing bonds with lower coupon rates become less attractive, causing their prices to fall. Conversely, when interest rates decline, bond prices tend to rise. This dynamic affects the value of bond investments and influences investor decisions.

LISTEN: Mouthy Money podcast on why the Bank of England is cutting the base rate

The bond market is influenced by various participants, including governments, institutional (i.e. major financial businesses) and individual investors. 

Central banks, such as the Bank of England, play a significant role by setting monetary policies that impact interest rates. 

Credit rating agencies such as Moody’s and S&P Global Ratings, assess the creditworthiness of bond issuers, affecting investor confidence and bond pricing. Understanding these players helps investors navigate the complexities of the bond market.

Why the bond market matters to private investors

For private investors, the bond market offers several benefits that make it a valuable component of a diversified portfolio. 

Here are four reasons why bonds and the bond market are relevant to individual investors.

1. Income generation

Bonds provide a reliable source of income through regular yield payments. For retirees or investors seeking steady cash flow, bonds can supplement other income sources, such as dividends or state pension. 

By selecting bonds with varying maturities and yields, investors can create a predictable income stream tailored to their needs.

2. Risk diversification

Bonds typically have a low correlation with stocks, meaning their prices often move independently of equity markets. 

During periods of stock market volatility, bonds can act as a stabilizing force in a portfolio. Government bonds, in particular, are considered safe-haven assets, offering protection during economic downturns. By allocating a portion of their portfolio to bonds, investors can reduce overall risk.

It must be caveated however that this is not always the case. In the recent selloff in markets over US President Donald Trump’s tariff war – both stocks and government bonds witnessed major falls in value. 

3. Capital preservation

For investors nearing or in retirement, preserving capital is a priority. High-quality bonds, such as US treasuries, UK gilts or investment-grade corporate bonds, offer a relatively safe way to protect principal while earning a return. 

Although bonds carry risks, such as interest rate risk or credit risk, selecting bonds with strong credit ratings and appropriate maturities can minimise these concerns.

4. Flexibility and accessibility

The bond market provides a range of options to suit different investment goals. Investors can choose short-term or long-term bonds, high-yield or low-risk bonds and domestic or international bonds. 

Additionally, individual investors can access the bond market through bond mutual funds, exchange-traded funds (ETFs), or direct bond purchases. These vehicles make it easier to invest in bonds without requiring extensive expertise or large capital.

Key considerations for private investors

While the bond market offers opportunities, it also comes with challenges that private investors should understand. 

Interest rate risk is a primary concern, as rising rates can reduce the value of existing bonds. Inflation risk is another factor, as rising prices can erode the purchasing power of fixed coupon payments. 

Credit risk – the possibility of an issuer defaulting – is particularly relevant for corporate and lower-rated bonds.

To mitigate these risks, investors should conduct thorough research and consider their financial objectives. Diversifying across bond types, maturities, and issuers can reduce exposure to any single risk. Working with a financial planner or using diversified bond funds can simplify the process for those new to bond investing.

Another consideration is the impact of taxes. Interest from most bonds is taxable. Investors should evaluate their tax situation and consult a tax professional to optimise their bond investments, using tax wrappers such as pensions or ISAs which can lower the tax liability on your portfolio. 

The bond market is a cornerstone of investing, offering private investors opportunities to generate income, diversify portfolios and preserve capital. 

By understanding what bonds are, how the bond market operates, and why it matters, investors can make informed decisions to improve their financial plans. 

Disclaimer

This article is produced for general informational purposes only. It should not be construed as investment, legal, tax or other forms of financial advice.

If in any doubt about the themes expressed, consider consulting with a regulated financial professional for your own personal situation.

Past performance is no guarantee of future results. Investments can go down as well as up and you may get back less than you started with. 

Investments are speculative and can be affected by volatility. Never invest more than you can afford to lose.

For more information visit www.fca.org.uk/investsmart

Photo by fauxels: https://www.pexels.com/photo/people-discuss-about-graphs-and-rates-3184292/

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Green investment is the big trend of our times says Helena Slater. Here’s what you need to look out for to keep up to date with it.

2020 was the ‘year of green investing,’ with companies shouting left, right and centre about their sustainability records, why they’re ‘ethical investors,’ and what they’re doing to make a positive impact on the world. 

And 2021 this trend shows no signs of slowing down.

But with terms like ‘ESG’ and ‘green bonds’ being thrown around, what exactly do they mean? 

Below I’ve broken down six of the most popular ‘green’ investment terms you’ve definitely heard of this year, even if you’re not quite sure how or where. 

1. ESG

ESG is a term that has grown in popularity over the past year among investors, be they professional or private. 

Together, these three letters form a set of standards for companies to use to screen potential investments. The level of scrutiny that companies use to examine can vary, but these have undeniably become the foundation to many investments. 

The letters stand for:

Environmental. This criterion relates to, as it suggests, environmental factors, such as pollution, deforestation, and biodiversity.

Social. The social criteria of ESG relates to the community, employees, and stakeholders that the company exists within. This can include issues such as race and gender equality.

Governance. This is how a company handles its executive pay, remuneration, and compliance with laws. 

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2. CSR

Corporate Social Responsibility or CSR is the means by which a company holds itself socially accountable. 

This is often looked at from an internal and external basis. As a result, this can encompass anything from promoting diversity in their workplace to ensuring the company has positive environmental impact. 

Some companies even go a step further and set up charitable foundations for a variety of causes.

3. RI

Responsible Investment or RI does as it says on the tin. This simply refers to an investment strategy which uses elements of ESG factors in order to make investments that have a positive impact on the world. 

In order to demonstrate their commitment to the RI, companies typically file RI reports on their activity on an annual or quarterly basis, which is always a great way to see where companies are concentrating their efforts to help save the planet.

4. Green bonds

Green bonds have grown in popularity over the past year, and there’s a reason for it. 

So-called Green bonds are financial instruments that are issued by companies (or now even governments) to raise funds for new or existing projects that benefit the environment. 

Since they began in 2007, they have received inflows of over $1 trillion according to the Climate Bonds Initiative, with last year seeing the largest ever number of green bond issuance ($269.5 billion to be precise).

5. Social impact bonds

Similar to green bonds, social impact bonds or social bonds are a financial instrument issued to raise funds for projects with positive social outcomes, whether they be new or existing projects. 

Some examples of projects social impact bonds have helped finance include providing educational tools for disadvantaged girls in India and more recently, helping those impacting by the coronavirus pandemic.

6. Transition bonds

Transition bonds are slightly newer to the table than their counterparts. Essentially, these are a means for a not quite so environmentally friendly company to transition to a greener way of doing business. 

These bonds have been the source of quite a bit of debate, however, as they enable high carbon-producing companies, such as energy companies, to boost their image to appear more sustainable without making the effort to do so. 

For the companies who use transition bonds correctly, these are an excellent way for companies to transition into more climate-friendly business models.

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Mouthy Money co-editor Edmund Greaves appears on talkRADIO to discuss a plan to offer green savings bonds to the public through NS&I, what to do about council tax rises and why one broadband provider is stealthily hiking its prices. Listen in the Soundcloud player below.

With thanks to talkRADIO.

Photo by Sam Forson from Pexels

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