Bonds are basically loans, made by investors to companies. The companies pay interest on the bonds during their term, and pay back the original amount at the end. However, there is a risk that a company might not be able to repay its debt – most famously in the case of the collapsed, fraudulent US energy company Enron - so bonds are rated according to the their issuing companies' financial strength. The main rating agencies are Fitch, Moody's and Standard & Poor's.
The safest corporate bonds are known as investment-grade – these are bonds rated BBB or above (by Standard & Poor's). Riskier bonds are known as junk bonds or high-yield bonds. And, as the name suggests, there high-yield bonds pay out a higher level of income to reward investors for taking on higher risk. You can also invest in government bonds. UK government bonds, known as gilts, are regarded as being risk-free investments, safer even than AA-rated corporate bonds. On the other hand, bonds issued by governments in emerging markets can be pretty risky.
Bonds have both an income value and a capital value. They pay out interest, known as a coupon. The coupon is the yield at issuance. However, bond yields vary in relation to interest rates. If interest rates fall, bond prices will rise and bond yields will fall. If interest rates rise, bond prices will fall ad bond yields will rise. Hence, the important figure to look at is the running yield.
The intital price of a bond is call par – if you invest in a bond at issuance and hold it to redemption, you should receive its par value back. However, because a bond's price can vary during is life, you would suffer a loss on maturity if you bought above par (or vice versa). This is reflected in the redemption yield.
Losses or gains depend on how long a bond has to maturity (known as duration). Each percentage point change in interest rates is magnified by the number of years to maturity. For example, a 1 per cent rise in interest rates would lead to a 5 per cent call in the value of a bond with five years left to maturity.
But bonds can act as good portfolio diversifies for investors because they tend to perform differently from shares. This is known as having a low correlation. For example, when stock markets fell between 2000 and 2002, central banks cut interest rates to stimulate economic growth. In turn, bond investors enjoyed rising capital values, offsetting the losses on their equity holdings.
Gilts and corporate bonds have a low correlation with shares, Gilts have a -1 per cent correlation with shares (and corporate bonds have a 90 per cent correlation with gilts). By contrast, high-yield bonds have a 50 per cent correlation with shares and just a 15 per cent correlation with gilts.
Ben Yearsley, of independent financial advise Hargreaves Lansdown, argues: "The general outlook for bond funds is unexciting. Why bother going into a bond fund paying 5.5 per cent with some risk when you could be in a bank account paying 5 per cent with no risk?"
Bonds offer an income advantage over shares, though, when held in an individual savings account (Isa) because interest is paid tax-free, whereas dividends on shares are paid out net of tax, which can no longer be reclaimed in an Isa.
Mr Yearsley therefore recommends picking "a bond fund that can invest across the spectrum to give you the possibility of higher returns." At the 'spicer' end, he favours Royal London Strategic Bond (managed by Paul Doran, Eric Hold and Stephen Booth).
As lower-risk options Mr Yearsley backs Aegon Sterling Corporate Bond (managed by David Roberts) and the ultra-conservative Standard Life AAA Income (managed by Andrew Sutherland). Mr Yearsley suggests holding gilts directly, rather than paying a management fee.
You can buy individual bonds (as well as gilts) through a stockbroker. Individual bonds (and gilts) can be held inside Isas, provided they are investment-grade and have at least five years to maturity at the time of purchase. However, it can be hard for private investors to research bonds. Price and credit ratings for some bonds are available at www.bondscape.net.
Another problem is that bonds tend to be traded in fixed lot sizes. A £1,000 lot size is manageable, but lot sizes of £10,000 or £50,000 could be problematic for small investors.