The term bond is broadly used in the financial industry; here we concentrate on the “investment asset” often known as fixed interest, fixed income, debt securities, gilt edged securities (GILTS) or T-Bills. If a Corporation or Government wishes to raise capital it can borrow money from a bank, release shares (corporations) or issue a bond. In buying a bond, we as investors, are effectively lending them money. This is different to a share as we are owed this money back instead of investing into the chance of future profits.

Therefore a bond is an IOU which when issued has a fixed maturity date when you will get your original stake back, plus an annual ‘coupon’ – the interest paid. If you hold the bond from issue to maturity then you should receive all of your money back and the annual ‘fixed interest or income’. Your risk is whether the company can afford to pay the coupon every year and whether they will still be in business when the bond matures.

If a company or government goes bankrupt, the bond holders are considered as creditors and are paid back well before the shareholders. The coupon must also be paid before any dividends are paid to shareholders. This is why bonds are considered to be lower risk than equities/shares. You can assess the default risk by looking at the ‘credit rating’ of the company as defined by credit rating agencies. Generally AAA – BBB are for the higher quality (Investment Grade) bonds; BB - C or D are for lower grade (Junk or High Yield bonds).

The interest you receive as an investor is directly linked to the risk that you take. A huge multinational firm with a high credit rating and strong balance sheet is much more likely to be able to pay back its debt and coupon than a new small sized company. It will therefore issue a bond with a lower coupon as it is offering greater security. A government theoretically can’t go bust; this means that the interest on government bonds (Gilts in UK, Bills in US) is generally lower still.

If an investor doesn’t want to hold the bond to maturity then they can sell them on the ‘bond market’. The pricing of bonds is primarily affected by interest rates. Generally if interest rates rise then the value of the bond will fall and vice versa. Changing interest rates therefore affects the ‘yield’ of the bond.

For example – a bond issued at 100p with a coupon of 7p, has a ‘yield’ of 7%. If interest rates go up then the price falls and you might buy the bond for 90p. You will still receive the 7p coupon so the yield is therefore now 7.7% (7/90 x 100).

Many people choose to access bonds through a collective investment. These are often called ‘fixed interest funds’ though this title is slightly misleading. A fund may have many bonds within it, most of which may not be held to maturity, so the interest is not ‘fixed’ it is normally quoted as the average yield of the fund on any given day. This yield will change as the manager buys and sells different bonds. Managers have very different styles and mixtures of bonds so an understanding of the type of fund to buy is important. The advantages of having a bond fund as opposed to individual bonds include; professional management, diversification, globalised spread of assets and currencies and lower management costs. Bond funds are an excellent addition to any portfolio and even adventurous investors should have some exposure, e.g. 15-20%. Cautious or income investors should have significantly higher amounts.

This article is for information only and should not be considered as advice.

Peter Brooke is a financial planner to the English speaking expatriate community. He is based on the Cote D’Azur and is a member and partner with the Spectrum IFA Group. He can be reached on +33 6 87 13 68 71 or peter.brooke@spectrum-ifa.com.

This article was published in the May 2009 edition of Dockwalk magazine