Zero coupon bonds are therefore sold at a discount to their face value. There are two very different reasons why various investors like zero coupon bonds. For one group, the absolute certainty of receiving a fixed amount on a fixed date in the future is extremely valuable. Another group of investors likes zero coupon bonds because of their sensitivity to rate changes. Because all of the return of a zero coupon bond gets incorporated into its price, changes in rates have a more dramatic impact on zero coupon bond prices than with their interest-paying counterparts.
The longer the maturity, the greater the price sensitivity. Therefore, if you want to bet on interest rates moving a particular direction, zero coupon bonds are your best way to maximize profit from any given rate move. For some investors, being more sensitive to rate changes is a negative rather than a positive. If you don't intend to hold your bond to maturity, you have to stay aware of market fluctuations, and extreme volatility for zero coupon bonds can work against you if rates don't move the way you want.
Specifically, if rates rise, they make the value of your zero coupon bond go down, potentially forcing you to sell at a depressed price if your timing is bad. Another problem with zero coupon bonds is that IRS laws typically force you to recognize taxable income every year. Despite the fact that you don't actually receive an interest payment in cash, the IRS requires you to impute the amount of interest you should have gotten, based on the initial yield.
Fortunately, you might be able to avoid this issue by holding zero coupon bonds in a tax-favored account like an IRA. Despite their dangers, zero coupon bonds let you do some unusual things. Rate speculation can be risky, but the rewards can be impressive if you make the right bet. Meanwhile, if you have specific cash needs at a given time that you don't want to leave to the whims of market fluctuations, then locking in a fixed return by buying a zero coupon bond can be the simplest way to meet your financial goals.
Dan Caplinger has been a contract writer for the Motley Fool since As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world. Follow DanCaplinger. Premium Services. Stock Advisor Flagship service. Rule Breakers High-growth stocks. View all Motley Fool Services.
Price volatility in bonds is generally lower than that seen in equities. Risk adverse bond investors should restrict themselves to gilts and investment grade bonds and run a diversified portfolio. Some issuers are more credit-worthy than others. For more on this subject see "Credit rating explained".
Also consider that the longer until the maturity date of the bond, the more you are a hostage to the future movement of interest rates and inflation. In this event the issuer may be unable to pay the coupons or the capital principle. However, the bond holders will have at least some priority over the assets of the issuer, ahead of the holders of ordinary shares. Inflation is a major risk. Over longer periods of time this may erode the return of a bond portfolio, causing the value to fall in real terms. The outlook for inflation will have an impact on the market value of the bond and therefore if you sell before maturity it will impact on the value.
Credit quality is a measure of the issuer's ability to service and repay its debt. Investors may have their own knowledge and views on a company's ability to repay debt or, alternatively, they can view the credit rating assigned to issuers by several of the credit rating agencies.
Credit agencies deploy considerable resources to assess both the issuer and the individual bond. It is in the interest of bond issuers to obtain these ratings. That said, it is the company itself which pays the ratings agency to rate their bonds and that does create a potential conflict of interest. Credit ratings are used by most banks and fund managers when establishing the suitability of a bond as an investment but, remember, situations change quickly, and so can credit ratings.
Much research on this subject is also conducted by broking houses and investment banks, as well as some good up and coming independent analysts. However it is worth bearing in mind that movements in the issuer's share and bond prices will usually occur prior to any change in the credit rating. As a rule of thumb, investors managing portfolios where the risk should be relatively low, and security of income and capital is more important, will restrict themselves to bonds rated AAA and AA, with perhaps a few single A investments.
Consider also a bond's credit history. Has the rating improved or declined over time? Bonds subject to a potential re-rating will be on 'credit watch'. It is worth considering the different classes of issuer that are on the Sterling bonds markets:. As a rule of thumb, the bonds with the least risk of default are the high quality sovereign issuers such as the UK and the larger and wealthier European countries. Ranking alongside these are the Supranationals - agencies such as the World Bank and the European Investment Bank which are supported by their sovereign members.
Second to this are the second-line countries, and those experiencing some economic difficulty. Here we would give Italy and Japan as two examples. While these countries do not quite have the economic strength of some of their peers, this type of debt should not be confused with emerging market bonds, which carries a much higher degree of risk. Finally we have corporate bonds. These are bonds issued by corporations, typically large quoted companies. The life of a company is full of ups and downs and it is fair to say that in most cases corporate bonds carry a greater risk than those issued by major governments or banks.
Factors affecting a company's credit rating include cash flow, profitability, asset valuations and unforeseen events such as legal action, a takeover or a change of the trading environment. The yield on these bonds will normally be greater than that available on bank debt. Other types of issuers: There are numerous bonds issued to fund mortgage loans, credit card loans and other more complex financial transactions.
These types of bonds, often known as mortgage-backed securities MBS and asset-backed securities ABS are not generally available to the investing public in the UK. The credit quality of these can vary and investors should be sure of their suitability before buying. To a degree, yes. The perception of risk will tend to fluctuate less. However, the influence of interest rates, both in the present and to come will exert a similar influence on both highly and lowly rates bonds alike. The expression 'junk' bond is an informal term for a non-investment grade bond, i.
In truth the term junk is often a rather harsh description and the majority of these bonds will live a useful and uneventful life, servicing both coupons and redemption payments. Nevertheless, a risk of default is implied in the name and caution should be applied when dealing in these assets.
Yes, although the ratings that we follow are described as "long term ratings" by the two main agencies, they can swing around quite quickly as perceptions change. Corporate bonds are even more subject to change as their issuers may be impacted by adverse trading conditions. Leveraged takeovers, in particular, can have a sudden and disastrous impact on credit ratings. Investors will generally buy a bond for two reasons. The first is to lock-in a known future income stream.
The second is to attempt to benefit from rising bond prices.
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But what would cause the value of a bond to rise? As with all traded assets, it will be down to supply and demand. There are two main variables affecting the price of bonds, the first being interest rates and the second the perceived credit quality or risk of default for the bond. As interest rates fall, a bond paying a fixed rate of interest every year will become increasingly sought after by investors. Conversely, rising interest rates, perhaps accompanied by inflation, will make the fixed income stream unattractive to investors and the market price will fall.
This relationship between price and yield is the key to understanding the factors moving the fixed income markets. To understand the return on fixed income instruments is to view a bond as a series of discounted cashflows. At the start of the period, the investor pays out cash to purchase the bond.
Over the course of the bond's life, the investor should then receive several payments, usually one or two a year from interest payments and a final repayment at the end of the bond's life-span. In this respect, bonds differ fundamentally from equities, where the future cashflows are unknown. Given future cashflows are known quantities, the relationship between the price of a bond and its yield is governed by mathematical formulae.
We are going to look at three methods of analysing a bond's yield; the income yield, the simple yield and the yield to maturity YTM. But what if you paid less than par for the bond? Assume we purchase the same bond for 95p. Our income or "running" yield would be:. Buying a bond above par has the effect of reducing the bond's income yield.
If you bought the bond above for p the income yield would drop to 4. The income or running yield sometimes also known as the flat yield does not take into account any profit or loss made by holding the bond to redemption, and simply assumes the investor will be able to sell the bond at the same price they purchased it for. For a more accurate measure of yield, we must turn to the yield to maturity, the standard calculation employed by market professionals, also known as the redemption yield.
Before we turn to the more complex and more accurate yield to maturity, it is worth considering the "simple yield". This is a good rough guide to the return available on a bond, and can often be worked out in one's head. Let us take another theoretical bond with one year left to run until redemption. Our return consists of two factors, the running yield over the month period and the profit made on maturity. From the point of view of the private investor, this type of calculation is perfectly adequate for assessing the return on a bond.
Known as the simple yield, the formula can be expressed as follows:. With longer dated bonds, the same theory applies, but to gain a more accurate measure, we must discount each future cash flow according to when it will be paid.
The formula used to calculate this is known as the yield to maturity YTM and is effectively the internal rate of return on the investment, allowing for each and every cash flow. The formula for this calculation is somewhat of a handful, and certainly not one for mental arithmetic. For readers who enjoy a challenge, it is:. In the case of a longer dated bond, with many more years to run until redemption, the price move will be considerably more.
This relationship between a given change in yield and the resulting change in price is known as the duration of the bond. Duration will have a considerable effect on the volatility of the asset over a range of different interest rate scenarios. Let's take three UK Gilts as an example calculations based on figures from June Note that the higher the duration of the bond the greater the price move shown per change in yield. Duration is governed by the length of time to maturity and the size of the coupon, in effect, the average period of all cash flows. A long dated bond with a low coupon will have the greatest duration, a short dated bond with a high coupon will have the lowest duration.
Investors looking to benefit from falling yields should look to add duration to their bond portfolios, defensive investors, or those envisioning a rising interest rate scenario will look to reduce it. The relationship between price and yield for a corporate bond is exactly the same as a government bond, and the same yield calculators can be used for both.
However, compared to a safe government bond, investors will demand an additional return for lending money to corporations due to the increased risk of default. This premium over the equivalent government bond yield is known as the spread. Non-government bond spreads vary greatly, with supranational agencies such as the World Bank trading at only a tiny fraction over governments while the debt of smaller, risky or unfashionable companies may trade at a level returning several percent or more over a government bond of an equivalent maturity.
Remember, corporate bond spreads reflect the market's view of the creditworthiness of the issuer. This opinion can change quickly, adding price volatility to this type of bond over and above that determined by interest rate fluctuations. Interest rates change over time, and bonds of different maturities will have different yields, reflecting the market's expectations for future interest rates.
Generally, investors will require an incrementally higher yield for longer dated securities. This means that long dated bonds generally yield more than short dated bonds. If investors expect interest rates to rise in the future, the price of longer dated bonds will fall, pushing up yields at the long end of the curve. Once you have determined which bond or bonds to buy, it is important to correctly identify it to prevent errors in dealing or other misunderstandings.
Each issuer may have several bonds trading in the market at any given time. Market convention describes bonds in the following notation: issuer, coupon, maturity. Thus, the BT bond illustrated below would be described as the "British Telecommunication eight and five eighths percent 26th March ".
However, we must also consider the factor of any accrued interest. If an investor buys a bond on its first day of issue, or just after the last coupon payment, the price seen on the screen will be the full price. However, when buying a bond part way through its coupon period for instance 6 months after the last coupon payment for an annual bond , there will be an adjustment for the income that has "accrued" to the bond. This is standard practice in the bond market and strikes a fair balance between buyers and sellers, as well as neatly differentiating between cash flows from income and those from capital gains.
This assumes that each month has 30 days, and each year has days. The market price is The settlement date is 31 May The bond pays a coupon annually and the last payment was on 26 March Note: The price shown on the screen will not include accrued interest and will be known as the "clean price". The effective price that you pay, including any accrued interest is known as the "dirty price".
The Debt Management Office produces a detailed document on calculating the accrued interest on Gilts which can be downloaded from their website. This covers the subject in detail, including the complex calculations performed on index-linked Gilts. At the risk of oversimplifying the subject, the main variations from the calculation process shown above are as follows:. The normal strategy for investing in bonds is typically "buy and hold". Remember, unlike equities there is no need to sell in order to realise your investment; capital will be returned to you on maturity.
However, from time to time investors need to sell a bond in order to raise capital, or perhaps to switch into other investment opportunities. In the event of this, bonds can be sold back into the market. Please note this market price may be higher or lower than your purchase price and this will impact the return you receive on the investment. When selling a bond, the accrued interest must also be factored into the calculation. In this case, any unpaid interest will be paid over from the new buyer to the seller, effectively the reverse of the scenario illustrated above.
If you're unable to find what you're looking for, please do not hesitate to call our Investment Helpdesk on or email us. If you are unsure of their suitability please seek advice. If you invest in small sums, the returns may be diminished by dealing cost. There are thousands of Sterling denominated bonds. Not all of them are liquid and we are unable to display accurate price data for all of them.
The bonds displayed are selected based on considerations of quality and liquidity. To deal in bonds not shown on this list, please contact us. Yes, the majority of SIPP schemes allow you to hold bonds. There is no theoretical barrier, however the bond must be listed on a stock exchange. No, you will receive a pro-rata payment known as the "accrued interest". Conversely, if you buy a bond part way through its coupon period, you will have to compensate the previous holder.
This way, the "clean" trade price of the bond is kept separate from the gradual roll-up of interest. Income from bonds is paid gross, but is taxable and thus should be recorded on your tax return. Profit on Gilts is free from capital gains tax CGT. The majority of Sterling bonds are free from capital gains tax, providing that they are "Qualifying Corporate Bonds". Broadly speaking this means most bonds apart from convertibles; however it is best to check if any individual issue is disqualified from this.
Note, caution should also be used with low or zero coupon bonds, where the capital gain may be viewed as income. A subordinated bond is an issue which carries less seniority in the "pecking order" of the company's balance sheet. When times are good, this will make little difference, but in the event of the issuer hitting hard times, the coupon payment on certain classes of subordinated debt may be waived see below. Also, if the issuing company is forced into liquidation, subordinated debt holders will only be paid out once senior debt has been repaid note: subordinated debt holders will, however, rank ahead of equity holders.
The ranking is as follows with guidelines of typical features :. The full details of a bond are available in the prospectus. These documents can normally be obtained from the Investor Relations department and often the website of the issuing company. Learn about bonds Welcome to the bond markets View bond and gilt prices. The key factors can be broken down as follows: Issuer - This is the entity which is borrowing the money. Typically these will be launched at "par" or p in the pound.
This coupon will generally be a fixed amount and is paid annually or semi-annually. Maturity - A date is set for the repayment of the money. This is known as the maturity or redemption date. The bonds will be redeemed at "par" or p in the pound with some rare exceptions.
However, if the issuer fails you might lose some or all of your investment and the income could stop.
Gilts or UK government bonds These bonds are issued by the UK government in order to finance public spending. Conventional Gilts The majority of Gilts pay a fixed coupon generally twice a year and mature at a set date. Retail Bonds These bonds are specifically issued for retail investors.
Other types of bonds Floating rate notes These are bonds where the coupon is not fixed, but based on a reference rate, typically LIBOR. Convertible bonds These are bonds where the holder may convert his redemption proceeds into the equity of the issuing company. Subordinated bonds The majority of bonds issued are "senior debt", meaning the holder has a priority claim on the company's assets, ahead of shareholders in the event of the company being liquidated. In terms of risk and reward, therefore, bonds generally sit between cash and shares.
Why choose bonds? Bonds and gilts offer security The risk of the UK or other major governments being unable to repay their debts is low and government bonds should be considered superior in credit quality to a bank deposit in theory. Return of capital Bonds also differ from equities in one other very important aspect.
Reliable income Bonds can add reasonably reliable income to a portfolio. Diversify your portfolio A well-managed portfolio should contain a variety of different assets classes.
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Fixed interest rates When an investor buys a fixed coupon bond, they lock in interest rates for a defined period. Speculation Any financial instrument offers the potential to speculate on future price movements, and bonds are no exception. Risk of default There is a risk that the issuer will be unable to return all or some of the capital and interest payments.
Market risk The bond's price will fluctuate from day to day according to the balance of supply and demand in the market, creating a paper profit or loss. Issue-specific risk Many bonds are issued with imbedded features such as "calls", which enable the issuer to repay the debt ahead of schedule.
Event and other risks This encompasses a variety of "operational" hazards such as a shift to an unfavourable or punitive tax treatment, remember tax rules can change and any reliefs depend on your personal circumstances. Frequently asked questions Are bonds more, or less risky than equities? Are some bonds more risky than others? What happens if the issuer of the bonds goes bust?
Are there any other risks that I should be aware of? The prospectus for each bond will contain further details of risks. AA Very strong capacity to meet its financial commitments. It differs from the highest rated obligors only in small degrees. A Strong capacity to meet its financial commitments, but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.
BBB Adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments. These bonds are of a more speculative nature, and imply a certain degree of risk.
In view of this, the incremental yield available on the instrument must be adequate to compensate the investor for this risk. BB Less vulnerable in the near term than other lower-rated obligors. However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions that could lead to the obligor's inadequate capacity to meet its financial commitments. B More vulnerable than the obligors rated BB, but the obligor currently has the capacity to meet its financial commitments.
Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments. CCC Currently vulnerable, and is dependent upon favourable business, financial, and economic conditions to meet its financial commitments. CC Currently highly vulnerable. C May be used to cover a situation where a bankruptcy petition has been filed or similar action taken, but payments on this obligation are being continued.
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C ratings will also be assigned to a preferred stock issue in arrears on dividends or sinking fund payments, but that is currently paying. Types of issuer It is worth considering the different classes of issuer that are on the Sterling bonds markets: As a rule of thumb, the bonds with the least risk of default are the high quality sovereign issuers such as the UK and the larger and wealthier European countries. Will a highly rated bond be less volatile than a lowly rated bond? What are 'junk bonds'?
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Can credit ratings change? Price and yield To understand the return on fixed income instruments is to view a bond as a series of discounted cashflows. Simple yield Let us take another theoretical bond with one year left to run until redemption.