mandg spin free guide to bonds

7/28/2019 MandG Spin Free Guide to Bonds

1/16

A Spin-Free Guideto Bonds

S p i n - F

r e e G u i d e

Making sense of investments


2/16

2 M&G Spin-Free Guide to Bonds

Glossary 3

What are bonds? 4

Whats the difference between a bond and an equity? 5How are bonds different from other forms of savings and investments? 6

How do bonds work? 7

What affects the amount of money you could earn from bonds? 10

Why own bonds? 12

What type of bond fund is right for you? 13

Key questions to ask your bond fund manager 14

The M&G Fixed Interest team 15

Contents


3/16

3M&G Spin-Free Guide to Bonds

Glossary

BondA loan, usually to a company or government, for a specified term, usually at a fixedinterest rate.

Bond fundA portfolio of bonds you can invest in that is managed by a fund managementcompany.

CouponThe interest paid by the government or company issuing the bond.

DefaultWhen the bond issuer does not maintain interest payments or repay the face valueof the bond at maturity.

Distribution yieldReflects the amounts that may be expected to be distributed over the next twelvemonths as a percentage of the price of the bond fund at a particular date.

EquitiesAnother name for company shares.

GiltsBonds issued by the UK government (short for government gilt-edged securities).

Investment grade bondsCorporate bonds issued by companies with high credit ratings and considered tooffer lower risk than those companies with lower credit ratings.

MaturityThe date at which the issuer is obliged to repay the loan (also known as redemption).

Redemption yieldThe interest payment, also taking into account any capital gain or loss made

when the bond reaches maturity, as a percentage of the price of the bond fund.

Sub-investment grade bonds (also known as high yield bonds)Corporate bonds issued by companies with lower credit ratings and thereforeconsidered to offer higher risk, but the potential for higher rewards, compared withinvestment grade bonds.


4/16


What are bonds?

In the simplest terms, bonds are loans made by an investor to a government tofinance its spending or to a company which, for example, needs to raise additionalcapital to help finance new business opportunities.

Typically, the issuer of the bond will make a regular interest payment to thebondholder. This is called the coupon. The level of the coupon will be set when thebond is first issued.

Bonds issued by the UK government are called gilts (bonds can also be issuedby overseas governments), whereas bonds issued by a company are calledcorporate bonds.

Rather than invest in individual bonds directly, many people prefer to invest inbond funds. The aim of this guide is to provide you with the information youneed to know in order to understand how bond funds work.

There are many types of financial products that are described by theirpromoters as bonds, for example single premium investment bonds.These are not bonds in the sense discussed in this guide.


5/16


Whats the differencebetween a bond andan equity?

Shares, or equities, are a way of owning part of a company and sharing in itssuccess and failure.

Bonds, on the other hand, are debts owed by the issuing company or government to

their holders. They are generally affected by changes in interest rates and inflation.Their prices tend to move less sharply than equities so they might be regarded asa safer haven from market turbulence, but as they are debt instruments there is arisk that an issuer might default on its obligations. The likelihood of this happeningwill depend on the financial strength of the issuer. Gilts are generally perceived tobe risk free as the UK government is unlikely to default on its debts.

As neither bonds nor equities are free from risk, it may be wise to reduce the risk to

your investment by diversifying your portfolio to hold a combination of bonds andequities. That way you can add some degree of stability if markets fall.

If you are comfortable with taking a higher level of risk, for the potential of greaterreturns, your portfolio would probably lean more towards equities.

If, however, you want to take less risk with your cash maybe youre approachingretirement you may want to increase the percentage of bonds you hold.


6/16


How are bonds differentfrom other forms of savingsand investments?

Building society Bond fund Shares

Income Lower level of Higher level of Generally lower levelincome. income which of income which

can fluctuate. can fluctuate.Capital No opportunity Potentially some Higher opportunity

for growth, but opportunity for for growth, butcapital is secure.* growth. Capital is capital may fluctuate

not secure but, sharply. Capital isin the event of not secure.bankruptcy, holdersmay recover someof their investment.

*Up to 85,000 of your money is secure in a bank or building society, unlike a stocks andshares or fixed interest investment. (Financial Services Compensation Scheme, for claimsagainst firms in default from 31/12/10).


7/16


When you invest in a bond fund (also called a fixed interest fund), yourmoney is pooled with other investors money and invested in a wide range of individual bonds.

This diversification helps to reduce the risk to your investment since you arentreliant on the fortunes of a single company or government.

Whats more, you also benefit from having an experienced bond fund managerwatch over your investment.

A bond fund is made up of many individual bonds carefully selected by thefund manager. This is how those individual bonds work:

A government or a company issues bonds. A company may issue a bond tohelp finance new business opportunities, or a government may use it as a wayof helping finance their expenditure.

Typically, the bond will have a fixed life. The end of this fixed life is known as theredemption date but is also referred to as maturity .

The bond is issued at a fixed price. This is called the face value or the par

value . The issuer of the bond will repay the face value to the bondholder atthe redemption date. The face value may be different to the price thatwas actually paid for the bond as the bond may have been traded on thesecondary market.

Bonds can be bought and sold on the open market throughout their lifetime.Once bought, you do not have to hold it until the redemption date.

Although the price of the bond is set at the beginning of its lifetime and thebond will be redeemed at that price at maturity, its price will fluctuate betweenthese times. All bonds are affected by economic factors such as inflation,interest rates and economic growth. Corporate bonds are also affected by thefortunes of the company issuing the bonds, which will influence their ability tomake the interest payments and repay the loan.

Bonds are one of the most tax-efficient ISA investments you can

make, as under current tax regulations you benefit from a taxreclaim of 20% on interest distributions (although this could change inthe future).

How do bonds work?


8/16

8 M&G Spin Free Guide to Bonds

Risk and rewardAlthough bonds generally offer lower risk to your capital than equities, they arenot entirely risk free. The level of risk is based on economic factors and the abilityof the bond issuer to maintain the interest payments and repay the face valueat maturity.

Bonds that have been issued by the government are perceived as being low riskbecause it is unlikely that the government will default. Corporate bonds, on theother hand, carry a higher level of risk, as there is a greater chance that the issuingcompanies will default on the interest payments or fail to repay the face value of thebond at maturity. To compensate for the increased risk, they generally offer a higherinterest payment than government bonds. The level of interest offered on corporatebonds depends on the credit status of the issuing company.

Income and growthAs well as offering lower risk than equities, bonds are generally attractive if yourelooking for an income from your investment.

The income you receive from a bond fund is called the yield. Weve already talkedabout how the coupon rate is set when bonds are first issued this does not changeover the lifetime of the bonds. However, the prices of the bonds will change whenthey are bought and sold on the open market and this is why the yield on a bond

fund can vary from day to day.

There are two types of yield that you need to be aware of.

First, the distribution yield. This gives an indication of the amount of incomethat may be expected to be distributed over the next 12 months as a percentage of the current fund price, less fees and charges.

Second, the gross redemption yield. This also takes into account the coupon paidby the bond and any capital gain or loss that will be made if the bond is held untilmaturity and it does not default.


9/16


Face valueWe mentioned earlier that bonds are bought and sold on the open marketthroughout their lifetime, and the price paid for them during this time will dependon a variety of factors including the economic circumstances at the time. Atmaturity, however, the nominal amount of the bond, or the face value of the loan,should be repaid in full.

If a fund manager has bought the bond at a lower price than the face value andholds it until maturity, then assuming it doesnt default they will make a profit whenit matures. This is taken into account when working out the gross redemption yield.Obviously this works the other way round too if they purchase a bond at a higherprice than the face value, then a loss may be made if it is held until maturity.

The distribution yield reflects the amounts that may be expected to

be distributed over the next 12 months as a percentage of the currentfund price, less fees and charges.


10/16


What affects the amountof money you could receivefrom bonds?

As weve already mentioned, bonds are affected by a number of different economicfactors. Interest rates are particularly important as they affect the value of a bondsfixed interest payments. We have outlined below the way that these factors canimpact bond prices.

Before we start, you need to be aware of the difference between market interestrates and official interest rates.

Market interest rates are determined by the laws of supply and demand and reflectinvestors expectations of future inflation and official interest rates.

Official interest rates are set by the Bank of Englands Monetary Policy Committee

and they have a direct impact on the level of short-term borrowing and lendinginterest rates. Banks and building societies tend to raise their interest rates whenofficial rates rise and drop them when they fall.

What if

Market interest rates fall?Bond prices rise and yields will fall. The price of bonds that have a longer lifetimeuntil maturity will generally rise by more than that of bonds with a shorter lifetime.

Market interest rates rise?Bond prices fall and yields will rise. The price of bonds that have a longer lifetimeuntil maturity will generally fall by more than that of bonds with a shorter lifetime.

A companys credit rating is downgraded? (The credit rating gives anindication of a companys financial health and thus its ability to repay

its debts.)

A credit downgrade suggests that the risk of the company defaulting on itsobligations (either meeting the interest payments or repayment of the face value atthe maturity date) has increased. Therefore, the price of that companys corporatebonds may fall and the yield may increase. In this situation investors have to decidewhether the extra yield offers sufficient compensation for the additional risk.


11/16


The rate of inflation changes?

Inflation is the enemy of a bond investor. Inflation erodes the value of money andtherefore eats into the value of an investment paying a fixed interest rate. If a bondis paying a 7% yield but inflation averages 5% over the period for which the bondis held, the inflation-adjusted yield is only 2%. (This is called the real yield ). Incontrast, an inflation rate of 3% over the period means that the real yield will bedouble, or 4%. Falling inflation is good news for bonds. In order to protect againstinflation, you can invest in index-linked bonds where the interest and principalpayments are adjusted in line with a specific price index.

The governments budget deficit rises?If the government is spending more than it receives through taxation, it can borrowmoney by issuing more bonds. The basic principle of supply and demand will meanthat as the quantity of available bonds increases, the price people are preparedto pay for them will decrease and bond prices will fall. If the governments budgetdeficit falls, it will issue fewer bonds and prices will rise.

The economy goes into recession?As the economy slows, a number of the factors already discussed (inflation, the

governments budget deficit, interest rates) will influence bond prices. Weak growthis often accompanied by low inflation, and the Bank of England may reduce officialinterest rates in order to stimulate the economy. Therefore, bond prices mayrise. However, in a recession, the government may have more expenses (such asunemployment benefit) and lower tax revenues, so the budget deficit is likely to riseand increased supply means bond prices may fall.

The economy is booming?

Higher tax revenues and lower social security spending mean that the governmentneeds to issue fewer bonds, so bond prices will rise. However, the threat of risinginflation as the economy overheats may take the shine off bond prices.

The stockmarket crashes?Generally bond prices move less sharply than shares, so they are often regarded asa safe haven from stockmarket turbulence. Investors might switch some of theirholdings in shares into government bonds as the stockmarket falls, boosting prices.

The pound strengthens?In the UK, a strong pound lowers inflation by making imports cheaper. Thisis good news for UK bonds, which dont like high inflation. If you hold overseasbonds, a strengthening pound means that your investment is worth less whenconverted back into sterling from a foreign currency, even if prices in local currencyhavent changed.

A war, disaster or political uncertainty arises?Generally, the safe haven status of government bonds means that in timesof trouble, buyers fleeing uncertainty will push the prices up. In the event of awar involving the UK, bond prices may fall, as the government may be forced toborrow heavily.


12/16


A quick reminder...Bond funds are seen as an income generating investment; therefore they mightappeal to anyone with an income need (such as someone nearing retirement).

Because they offer regular, fixed rate coupons, investing in bonds can be a goodway of maintaining a steady stream of income. In addition, in times of low interestrates, the income received from a bond fund investment is likely to be higher thanthat offered by a bank or building society. Although, of course, a bank or buildingsociety is a secure place for your money, unlike a stocks and shares investmentwhere prices may fluctuate and you may not get back your original investment.

Additionally, someone who already has investments in the stockmarket mightchoose to invest in a bond fund in order to diversify the risk to which their savingsare exposed.

Why own bonds?


13/16


What type of bond fund isright for you?

The answer as to which bond fund is right for you depends on the degree of risk youare prepared to take to increase your potential return.

Gilts (British government securities)If youre looking for a solid investment that will pay you a regular income, you maywant to consider investing in gilts because, as we mentioned earlier, gilts areregarded the safest of all bond investments because they are backed by the UKGovernment.

Index-linked bondsIf youre worried about inflation and want to preserve your capital in real, that is,

inflation-adjusted terms then index-linked bonds may be for you.

These are bonds with interest and principal (the amount of the loan) paymentslinked to a specific price index such as the Retail Prices Index (RPI), which aredesigned to keep their real value.

Corporate bondsIf youre prepared to take on more risk in the hope of better returns, you might

want to consider investing in corporate bonds.Because they are issued by companies rather than the government, they offera higher interest payment than gilts to compensate for the fact that companiesgenerally have a higher risk of default than the government.

The interest payment, or coupon, varies according to the financial strength of thecompany. Credit ratings, which are assigned by internationally recognised ratingagencies, offer a guide to a companys financial strength and the risk of thatcompany defaulting. Bonds of highly-rated companies will typically offer yields thatare higher than gilts with equivalent maturities.

High yield corporate bondsIf youre prepared to take more risk in return for an even higher income, you couldchoose to invest in high yield corporate bonds.

High yield corporate bonds are issued by companies with a lower credit rating andoffer a higher interest payment to investors to compensate them for the greaterlevel of risk to their capital.

High yield corporate bonds often come with yields that are significantly higher thangilts with equivalent maturities.


14/16


1) What type of bonds does the fund manager invest in?When comparing bond funds, a good starting point is the type of bonds and therange of credit ratings in which the fund invests. You should be considering whether

the fund invests in gilts, investment grade bonds, sub-investment grade bonds, acombination of all three, or a wider universe.

In addition, you also need to know if the fund has a higher risk profile ie, doesit hold equity-like investments such as convertibles, preference shares or directequity holdings?

2) How does the fund manager generate income?

Income on a bond fund is produced by the coupons paid by the bonds inthe portfolio.

Importantly, the amount of income a fund pays out can depend on whether a fundcharges its expenses to capital or income.

3) How does the fund manager seek to manage risk?The main risk factors for bonds are interest rate risk and credit risk. Different

bonds carry different risks. High yield, or sub-investment grade bonds are generallymore affected by credit risk - the risk of default - than interest rate risk, whileinvestment grade corporate bonds have greater sensitivity to interest rate risk.

It is also important to consider how well diversified the fund is by asset class,geography, industrial sectors and issuers.

4) What is the research capability of the investment house?

While credit rating agencies have a useful role to play in increasing knowledgeabout sectors and companies, they are often slow to re-rate companies as theirfortunes change.

As bonds are loans it is very important to know as much as possible about thecompany or institution you are lending money to. Also, the documentationassociated with bonds can be very complex and it is critical to understand exactlywhat rights you have as a bondholder.

Key questions to ask yourbond fund manager


15/16



16/16

Further information For further information on the M&G

fixed interest fund range, simply callyour usual Financial Adviser.

Our website

www.m and g.co.uk

For more information on the M&Gfixed interest fund range and to accessdaily prices.

Email* us

info@m and g.co.uk

How to contact us

*Please note that information contained within anemail cannot be guaranteed as secure. We advisethat you do not include any sensitive informationwhen corresponding with M&G in this way.

mandg spin free guide to bonds

Documents