Investing in fixed income products can be done through many forms, but it usually occurs through the purchase of bonds, which are IOUs that governments or companies issue in order to raise money.

Governments usually do this so that they can pay for things like schools, hospitals, roads and defence, while companies usually use the money for expansion.

By buying a bond you are effectively buying a small part of a loan which has been taken out by either a government or a company for a fixed term.  Terms can range between one month and 30 years, but most bonds usually last for more than a year.

In return for lending them money, the government or company to which you have lent your cash is then obliged to give you regular interest payments. These can be paid annually, semi-annually, quarterly or even monthly. Bondholders receive a regular interest payment during the life of the bond, known as the coupon, plus their original capital, which is repaid to them when the bond reaches maturity.

It also means that, unlike equities, commodities or other riskier investments, bonds are often considered ‘safe’ investments, which are less likely to tumble in value when times are hard. They are often used by investors to diversify their portfolios.

Regular returms

“Fixed income bonds provide higher certainty of returns and have lower probability of capital losses than other investment products such as equity shares. Bonds also provide a regular income stream as interest earned on most bonds is paid out either quarterly or six-monthly,” says Anita Yadav, head of fixed income research at Emirates NBD.

Bonds are often confused with so-called “fixed rate savings bonds” which are actually a form of long term savings account offered by banks and building societies and not a bond investment at all.

But, as financial experts are required to point out, investing in bonds is far from risk-free. Both companies and governments have been known to default on their bonds, leaving creditors out of pocket.

Generally speaking, the higher the interest offered, the greater the risk. Government bonds usually offer a lower interest rate than corporate bonds because there is more chance of a company going bust. Governments can, theoretically at least, simply print more money in order to repay debts.

Nonetheless, different countries have different debt ratings depending on their ability to repay loans, with US treasury bonds paying a far lower interest rate than war-torn countries or nations whose finances are otherwise in a precarious state.

Companies, on the other hand, have no ability to print money and so, on average, offer higher interest rates. But these, too, are split between “investment grade” corporate bonds issued by big companies with a track record of paying their debts and riskier “junk” bonds issued by riskier corporates.

And, even if the issuer does not default, you can still lose money through investing in bonds.

Investors do not have to hold bonds until maturity, but can sell them on. This means they can trade at above or below their face value, depending on market conditions. If a company starts to struggle, its bond holders may find it difficult to sell their bonds, even if it continues to make regular interest payments on them.

Coupled with this is the threat of rising interest rates. Bonds pay a fixed rate of interest, which makes them less attractive when interest rates are rising, as you can get a better return elsewhere. If interest rates rise, then in order to remain competitive, governments and companies will offer bonds paying higher rates of interest, making the old bonds paying lower rates less appealing and so fall in value. 

“Quickly rising interest rates is bad and quickly falling interest rates is positive. The worst enemy of bonds is high inflation,” says Steven Downey, a chartered financial analyst at Holborn Asset Management. “In the 1970s and 1980s, long term US Treasury bonds lost 60 per cent of their value after inflation.”

Since the global financial crisis in 2008, not only have interest rates remained at record lows but central banks around the world have also been busy attempting to stimulate world economies by using so-called “quantitative easing”  - creating digital money and using it to buy government bonds.

Bubble trouble?

No-one really knows how this will all play out in the long term but many experts are worried that by creating extra demand for bonds through these programmes, governments are pushing bond prices up above their natural market level, possibly even creating a bubble in the bond market.

“The conventional wisdom of bonds being low-risk doesn't necessarily work today and so investors have to careful about where they are investing,” says Patrick Connolly, a chartered financial planner at Chase de Vere. “As a direct result of the actions of central banks, prices on many fixed interest assets, particularly government bonds, look expensive. This means they could be subject to significant falls in the future, which would be bad news for those relying on bonds to provide security in their portfolios.

“These risks would be greater if interest rates rise faster than expected, inflation increases further or when central banks reduce the financial support they are providing to their economies,” he adds.

Most investors do not buy individual bonds, but invest instead in a fund which buys a selection of different bonds with different risk profiles, maturity dates and offering different interest rates. Some funds invest in government bonds, some buy corporate bonds and some buy a mixture of the two. This mitigates the risk of investing in a single company, which could collapse.

“Investing in a single company, whether that is buying shares or bonds, is a high-risk approach, especially if the money represents a significant proportion of your overall portfolio. We have seen how even supposedly strong and secure companies, such as the high street banks, can get into financial difficulties,” says Connolly.

“Investors should try to hold a range of different types of bonds,” he says. “If they're investing in fixed interest to provide some security in their portfolio, then it makes no sense to be relying on just one type of corporate or government bond. Diversification can be achieved by investing in a number of specialist bond funds or selecting funds with a broad investment remit.”

Downey says that for investors with small pools of capital, the easiest way to invest in bonds is through exchange traded funds that will pool investor assets and charge a very low fee to manage a portfolio of bonds via a rules-based index. For those that want a more active approach, there are more expensive active bond funds which offer potentially higher returns.

He also says that it is best to spread your risk geographically, too, so you can to mitigate any regional risks rather than putting money into your local market.

“If investors have a knowledge edge then they can concentrate a portion of their assets locally, however, the vast majority of investors should be globally diversified,” he says.

(Reporting by Lucy Barnard; Editing by Michael Fahy)

(Michael.fahy@refinitiv.com)

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