An asset with fixed income
The largest potential pitfall is the risk that the issuer will default. In general, this risk is low, and lowest of all with Government bonds. However, the risk is higher with bonds as there is a greater chance that the company will default and be unable to repay the loan.
The value of Government bonds and corporate bonds will vary during their lifetime. If you sell them you might get back less than you initially invested.
The relationship to equities
Equities (stocks & shares) are less predictable than bonds, but over the long term, stocks and shares offer a larger potential for growth. But bonds still play an important role in many portfolios because:
- the interest payments can offer a source of income
- bonds can help with portfolio diversification, as bond prices are not affected by the same factors as stock prices
- they offer risk-averse investors a safer choice.
You can buy bonds directly from the market, where they are traded like shares. If you want to hold particular gilts or purchase bonds issued by a specific company, direct holding lets you buy exactly what you want. The market price of bonds and gilts can fall as well as rise. Depending on the buy and sell price, you may get back less than the initial investment.
If you want to hold a wide range of bonds, a bond fund or ETF gives you the advantages of pooled investing. With one purchase, you gain exposure to a range of bonds that fit into a particular risk profile or interest rate.
Rating agencies grade bonds on a letter scale that indicates credit worthiness and risk. In simplest terms, the lower the letter scale, the lower the quality and the higher risk potential:
AAA or triple A rating — indicates the highest-quality bonds that offer the highest protection for principal and interest payments;
A or single A rating — indicates good to medium-grade bonds;
BBB or triple B rating — indicates medium-grade quality bonds, with adequate protection;
Below triple B is considered speculative, high-risk securities and the category is referred to as junk bonds.
Most bonds carry a rating provided by one of the three independent rating agencies: Standard & Poor’s, Moody’s, and Fitch. From U.S. Treasuries to international corporations, these agencies conduct a thorough financial analysis of the entity that is issuing the bond. Based on each rating agency’s individually set criteria, analysts determine the entity’s ability to pay their bills and remain liquid and assign a credit rating to the bond. The bond rating is an important process because the rating alerts investors to the quality and stability of the bond. That is, the rating greatly influences interest rates, investment appetite, and bond pricing. Furthermore, the independent rating agencies issue ratings based on future expectations and outlook.