The bond market is the primary source of long-term finance for governments and corporations. Bonds pay interest at regular intervals until maturity when the investor makes the principal repayment. Bond prices rise when interest rates fall and vice versa.
There are different types of bonds available in the UK with varying degrees of risk. The main categories are government bonds, corporate bonds, index-linked gilts, covered bonds, and high yield or ‘junk’ bonds, also known as high-risk bonds (see below).
Each country has its unique bond market but trading these products often occurs across borders between investors who buy them from financial institutions known as primary dealers. As many companies see it beneficial to raise money through borrowing in different currencies, trading bonds can be complicated.
Governments issue debt securities to finance short-term deficits and long-term projects. When a government borrows money by issuing a bond, it essentially lends money to itself, which allows it to continue spending while also lending at a lower rate than if it had to go to the market and ask for loans from private investors.
The UK government issues Gilts (government bonds) and Treasury Bills (short-term debt). Gilts are issued with various maturities traded on the secondary market from 2 years to 30 years. The gilt price will rise or fall in line with interest rates; when rates fall, the value of gilt will increase.
Treasury bills are short-term instruments with a maturity of one year or less, and unlike Gilts, interest is paid at fixed intervals (e.g. annually). Private investors and institutions can hold government debt securities such as pension funds, life insurance companies, and investment trusts.
Like governments, corporations issue debt securities to finance capital expenditure projects or acquisitions. They also use bonds to borrow money from the market to meet temporary funding requirements when cash flow is low. Still, their operating cycle generates little revenue, e.g. during start-up periods or production downtimes. These types of bonds are known as ‘commercial paper’.
All corporate bonds pay an annual fixed rate of interest, which can be paid either in cash or by reinvesting the money into more bonds. The main types of corporate bonds are investment grade and high yield or ‘junk’ bonds.
Investment Grade Bonds
These are bonds that have been given an A rating or higher by one of the major credit rating agencies (see below for more information on ratings). They are considered low risk as the likelihood of the company defaulting on its debt is relatively small. Governments or large, well-established companies issue most investment-grade bonds.
High Yield Bonds
As the name suggests, high yield or ‘junk’ bonds have been given a lower credit rating by one of the major rating agencies. They are considered high risk as the bond company is seen as more likely to default on its debt. High yield bonds are usually issued by smaller, less well-established companies and pay a higher interest rate than investment grade bonds to compensate investors for the increased risk.
As the name suggests, index-linked gilts are government bonds linked to a particular stock market index. This means that the value of the bond will rise or fall in line with fluctuations in the index. Governments usually issue them as a way of protecting investors from inflation.
Covered bonds are a type of secured bond, meaning that the issuer of the bond has used specific assets as collateral against the loan. Suppose the issuer defaults on its debt, the holder of the covered bond can seize these assets and use them to repay the money they are owed. Covered bonds are popular in Europe and are typically issued by banks.
The most common way to trade bonds is through a bond broker. A bond broker will access various products, including government bonds, corporate bonds, and index-linked gilts. They will also offer quotes for buy and sell orders, allowing investors to get the best price for their product. Saxo has brokers ready to assist you with all your trading needs; check them out today!