Beginner's guide to bonds
If you're confused about the different types of bond, we explain how they all work.
The common theme with bonds is that you’re effectively lending money to an organisation or country for a period of time. In return, you’ll be paid regular rewards – normally interest – during the period of the loan, and then you’ll get your money back at the end.
However, the safe return of your money can’t always be guaranteed and the level of risk depends on what kind of bond you have. Let’s look at the different kinds of bond and how much risk is involved.
Cash bonds are a type of savings account, often known as a fixed rate bonds. You invest a lump sum in one of these bonds and your money is locked away for anything from six months to five years, during which time you earn interest.
Generally speaking, the longer you lock your money away for, the higher the interest rate. Coventry Building Society currently pays 3.65% on its one year bond (issue 134). You can invest as little as £1 or as much as £250,000.
Alternatively, the Bank of London and the Middle East (BLME) offers a five-year Sharia’a compliant bond with an expected profit rate of 4.6%. However, the minimum investment is £25,000.
For a smaller investment, you could choose the five-year fixed-rate bond from BM Savings which pays 4.2% - the minimum deposit is just £1.
Money deposited with a bank or building society in a cash bond is protected by the Financial Services Compensation Scheme for amounts up to £85,000 per person, per institution. This means if a financial institution fails, you will get your savings back.
Interest rates on these bonds are normally fixed and if you want to withdraw money early, you’ll usually have to pay a penalty.
Financial purists would say that cash bonds aren't true bonds, they'd reserve that term for government and corporate bonds. So let's look at bonds offered by governments.
Governments around the world issue bonds to raise money, including the UK where they’re also known as gilts. They can be conventional bonds (with fixed payments) or index-linked bonds (payments change according to inflation).
You can buy bonds when they’re first issued by a government or buy them from other investors on the markets. That’s one of the great attractions of government bonds, you can easily sell your investment via the markets. That said, you may not get back the price you paid.
The price of government bonds is driven by several factors but risk is probably the most important. For example, investors are understandably nervous that Greece may not be able to pay back all of its debts, so the price of Greek government bonds has fallen and the yields have gone up.
US and UK government bonds are usually regarded as safer bets, so the price of these bonds has risen in recent times.
Read more in Why gilts matter.
Retail and corporate bonds
Corporate bonds are similar to government bonds except they’re issued by companies. Because companies are normally seen as riskier bets than countries, you’d normally expect corporate bonds to pay a higher interest rate than a government bond.
Until recently, few private individuals bought corporate bonds, but that’s changed as several companies have launched corporate bonds that are aimed at ordinary people. These bonds are often known as retail bonds. Over the last year or so, retail bonds have been launched by Tesco, National Grid and John Lewis amongst others.
The latest retail bond comes from Icap which pays 5.5% a year for six years. The bond requires a minimum investment of £1,000 and has a deadline of 24 July.
Corporate and retails bonds can be a good way to lock in decent returns but there is no certainty that your money is safe. Big brand names like Tesco aren’t regarded as companies likely to default, but you still have to appreciate there is some risk. Unlike savings bonds, government and corporate bonds are investments and are therefore excluded under the FSCS.
It’s worth noting that as a bondholder, you would stand ahead of shareholders in the queue for your money back if a company were to go bankrupt. But if the company’s debt is very large, there could still be nothing left for bondholders either.
Small companies trying to bypass banks and expensive business loans are increasingly looking to their fans or customer-base to raise capital.
In return they’re offering perks, discounts or free stock instead of traditional interest payments.
One of the latest offers comes from Leon – the healthy fast-food restaurant chain, which pays up to 15% interest on sums invested for three years in the form of £eon pounds to be used in-store. Read the full details in Leon offers bond that could pay 15% interest.
Hotel Chocolat, the high-street chocolatier, and travel website Mr & Mrs Smith have offered similar-style bonds in the past.
But with these types of bonds there is no safety net if the company fails. You might get less interest than was promised, none at all, or in the worst case scenario you could lose your original investment. Your money won’t be covered by the FSCS.
How to invest
With cash bonds you can invest directly with the bank or building society. To find the right account for you paying the best rate of interest, compare savings accounts.
Government bonds are available via stockbrokers or the Debt Management Office, but would also typically be found in the portfolios of investment funds, many of which will focus on bonds specifically. Read more in How to buy gilts.
The same is true of corporate bonds, which are also available via stockbrokers and the Order book for Retail Bonds – launched by the London Stock Exchange in 2010. Read more in Boost your income at low risk.
For mini-bonds you invest directly with the company. They crop up intermittently and you have to be on the look-out.