It’s not unusual for commentary on share price movements or cash interest rates to fill newspapers and, depending on the company, dinner conversations. However, bonds don’t attract the same level of discussion – despite being regarded as a way to diversify and balance the risk of shares and property against the safety of cash.
How do bonds work?
As ING senior economist Ian Bright explains in the video How bonds work, a bond is a loan. Or, more technically, it is a large loan that has been split into packages and sold to investors. Bond holders typically make money by receiving regular payments of interest (known as coupons) during the life of the loan. The life of the loan might be as short as one or two years or as long as 30 years or more.
The idea is that when the loan ends, their original investment is returned. However, as with any investment, there is a financial risk: investors can lose money. Bonds can be seen as a sort of halfway house: safer than shares but more risky than a bank deposit.
A bundle of company bonds please
Investors can buy individual bonds or units in a bond fund. Like shares, bonds or bond funds can usually be sold at any time – meaning they tend to be highly liquid. The two main types of bonds are corporate (loans made by companies) and government (loans made by government).
Of the two, corporate bonds are seen as more risky because the likelihood of a company issuing the bond going bankrupt is generally higher than a government doing so.
Bonds and the financial crisis
Our four tips for bond buyers explains that when interest rates rise, bond prices typically fall. For example, interest rates were at record lows in many countries during the global financial crisis in 2007, but began rising eventually, after recovery took hold. However, awareness may not be high: a 2009 US survey suggested that only 21% of respondents know how bond prices and interest rates relate to each other.
Different types of bonds are designed for different financial conditions. In particular, bonds linked to the Consumer Prices Index (CPI) are designed to protect against inflation, which can eat away at the spending power of money over time. This can be attractive to investors who want to ensure the value of their investment does not fall if prices rise.