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Understanding bonds

Bonds are used by companies and governments to borrow money from investors and they usually have a fixed length or term.

The issuer of the bond (the company or government) agrees to make fixed interest payments to the bondholder (the investor) at regular intervals during the term of the bond. These interest payments are called coupon payments. At the end of the term (known as the redemption date) the issuer repays the original amount borrowed to the bondholder.

The interest, or coupon, paid by a bond depends on the stability of the issuer. If the company or government is very stable and financially secure, then there is a lower risk of not being able to repay the loan so the interest rate paid can be lower. If the company is less stable, then the interest offered will be higher to reflect the risk you’re taking.

Before you choose an investment, you should be aware of the possible rewards and be comfortable with the level of risk involved.

Rewards

Bonds provide a regular income that is unaffected by interest rate movements. This allows you to ‘lock-in’ to a fixed income that can potentially pay more than a bank or building society, though your capital is not fully secure. The Bond issuer’s stability determines how much prices can change in the short term. Lower risk bonds, such as those issued by the UK Government, mean that your investment is relatively secure, with prices showing only small movements from day to day. More risky investments such as ‘junk bonds’ can show very pronounced price swings.

You don’t have to keep your bonds until the issuer repays – you can sell your bonds to another investor at any time. The price you get might be more or less than if you kept the bond until the redemption date.

Risks

Bonds are effectively loans and so their value depends on the ability of the borrower to pay you regular interest payments and refund your loan on the redemption date. If a company has issued a bond, but then runs into financial trouble, there might be concerns about the company’s ability to meet the terms of the loan and the price of the bonds could fall significantly. You can safeguard against this risk by diversifying – investing in bonds issued by a variety of companies and governments.

Though the income is stable, the value of bonds can alter depending on changes in interest rates. For example, when the Bank of England changes interest rates in the UK, your bond will be more or less valuable depending on the direction of the interest rate changes. If you buy bonds from overseas institutions you could also be affected by currency risk.

Important information

The value of investments and the income from them may fall as well as rise and cannot be guaranteed. Investors may not receive back the full amount originally invested. Past performance is not an indication of future performance.

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