Investing basics: why invest in bonds?

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Holly Black: Welcome to the Morningstar Investment Board. I'm Holly Black. And today, we're talking bonds. So, in investing, stocks and shares tend to get a lot of the attention because they're more exciting, but bonds are a great investment to have. In your portfolio, usually the way you would access those is through a fund because they're more difficult to buy than shares. Why would you invest in a bond? Primarily because it pays an income which a lot of retirees like, and for anyone who is building their pot of money, that's great because the income you get, you can roll back up into your investment pot and you've got more money to grow in the future. 

So, a bond is basically an IOU note issued by a government or a company. And they're saying, oh, if you lend me £10,000 for 10 years, I will pay you interest, I mean, in today's world, of 3 per cent year. And at the end of that time you'll get your £10,000 back as well, promise. So, that's great, because that means for the next 10 years if I hold that bond the whole time, I know I'm going to get 3 per cent of £10,000. So, I get £300 a year. So, after 10 years, I've had £3,000 in income. And then, I get my original money back. Brilliant. 

But there are risks with bonds as well. So, bonds tend to be rated on a scale from AAA and depending on what scale you're looking at down to C. AAA – you might think of batteries in the investor world. We would think that that is a really safe secure company or government. They are very unlikely to go bust and not give you your money back. C – we're moving into something called junk bonds or high yield bonds, and perhaps their financial situation isn't as good and there is a chance you might not get your money back at the end. The benefit of that is, a C-rated company might pay you more, pay a higher coupon than the A-rated one. They might pay, say, 2 per cent. So, you have to do the risk-reward maps there.

But there is another way that you can make money from a bond investment as well. And that is the price of it. So, a bond is issued at what's called par price. So, for the sake of argument, say, each bond is issued at 100P. Once the price moves, you also can make growth. So, if the next buyer who comes along is willing to pay 105P for that bond because they think it looks great and they really want the 3 per cent income, then you'd also make 5 per cent capital growth on your £10,000. You don't get your income anymore because you've got to sell your bond, but you make some money, right? 

And why would the price change? Well, a couple of main reasons. One is perhaps the company has become stronger. Perhaps it was C-rated, and it's moved up to B. Or it could be to do with interest rates. So, we know interest rates are rock bottom right now. So, perhaps, when you got your bond that pays 3 per cent that wasn't so attractive, now with interest rates at 0.5 per cent it's really hard to find that income on the market, so people are willing to pay a premium for that. Of course, it can happen the other way as well. And if the company gets into dire straits or interest rates go up and you can now get a better coupon elsewhere, then you might find that that goes down. And you can lose your – while your income will stay the same, you'll lose money on your capital growth. 

And that's basically how bonds work.

This report appeared on 2022 Morningstar Australasia Pty Limited

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