WiseAlpha’s educational series: Teaching you everything you need to know about the bond market and more.
Knowing the difference between different types of bonds could save or make you money.
A bond in its simplest form is a loan issued by a government, company or other institution. Instead of taking the loan out through a bank, the borrower approaches investors for capital.
The borrower promises to pay a fixed rate of interest or coupon for a fixed period at regular intervals until maturity, upon which they will repay the original capital back to the investors (bondholders).
Companies often issue bonds as a way of financing expansion, rather than issuing further shares.
Within the bond market, there are different types of bonds.
Corporate Bonds are issued by companies and can have varying degrees of risk and thus different rates of returns.
Investment grade or high grade bonds are bonds that refer to large corporates which are viewed as having a low risk of default and will normally be rated by S&P between BBB and AA. Returns currently are between 0.5% and 3.0%.
Senior secured bonds refer to a segment of the bond market which is extremely popular with specialised funds and high net worth investors. Many large corporates in the UK, particularly brand name companies issue bonds in this part of the bond market. The terms of these bonds vary from 5–7 years.
These bonds carry more risk than government bonds or high grade bonds as the company can have between 30% and 50% of it’s overall value in the form of debt (i.e. the bonds and other borrowings) with the remainder of the company’s value represented by equity or subordinated capital. However returns can be much higher in the range of 5–8%.
‘Senior Secured’ is market convention terminology that means a bond has a first right to assets of the company over unsecured creditors in the event of a liquidation. Assets may include property, equipment, cash, and intellectual property.
This means that if for any reason security over the company is enforced by lenders, senior secured bond holders will receive proceeds with first priority to any junior or subordinated debt holders and until the principal amount of the senior secured loan or bond has been repaid. However assets of the company may still not be enough to ensure a full recovery for senior secured bond holders in the event of a company liquidation.
High yield bond
High yield bonds are commonly known in the investment industry as unsecured or second ranking bonds) are not first in line for a repayment if the company has financial difficulty and the risk to an investor’s capital can be much higher.
However, this higher risk tends to be compensated by higher coupons or returns.
High Yield bonds do however have greater scope for price appreciation in the event of an upgrade in the rating of a bond, or during an economic upturn, or after improved financial performance at the issuing company.
Senior Secured and High Yield corporate bonds can therefore be an interesting way to generate potentially more attractive and stable income returns while diversifying traditional portfolios which are weighted to stocks, government bonds and cash savings accounts.
Gilts or UK Government bonds
These are bonds issued by the UK government in order to finance public spending. UK Gilts are rated AA by S&P and Aa2 by Moody’s and are viewed as having an extremely low risk of default.
Consequently, these types of bond have the lowest yields or returns of any bond type in the UK for a given maturity.
At the time of writing, 2 year gilts have a return or yield of 0.46% and 30 year gilts have a yield of 1.92%.
Fixed Rate Bonds
Fixed Rate Bonds are issued by banks for a variety of fixed terms.
A fixed rate bond is a security that pays a fixed pre-determined distribution or coupon. The coupon of a fixed rate bond will be set at the time of issue and not change during the life of the bond.
At the time of writing these bonds offer returns of between 1.75% to 2.55% for terms typically between 1 and 7 years.
Please remember that bonds are investments not savings or deposit protected products and your capital and interest is at risk.
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