What is a bond?

In stark contrast to the volatile world of stocks and shares, bonds emerge as a less hazardous investment alternative. We take a look at them in this feature – the second instalment in our “What is…” series.

Bonds can be one of the most complicated investment areas because of the number of different product classes available. In this article, we will focus on the basics.

In short, a bond is like an IOU. Thankfully, bonds are somewhat more secure than the scraps of paper written by Harry (Jeff Daniels) and Lloyd (Jim Carey) in “Dumb & Dumber”—in fact, they are formal contracts.

When a company (or indeed, government) wants to raise funds, they may well look to issue bonds. Investors buy the bonds (i.e., lend money), and in return, receive a note binding the company to a fixed agreement.

Under this agreement, the company is obliged to pay regular interest at a predetermined rate (called the coupon) to each of the bond holders (lenders) over a fixed period, after which, the initial sum of money (called the principal) is repaid.

John Ditchfield, a managing partner at Barchester Green, adds his own definition: “Corporate bonds and government bonds are fixed interest securities that pay investors a regular yield, normally related to the financial strength of the issuer (i.e., the bigger and more financial stable the entity issuing the bond, the lower the level of interest it then pays to investors).”

Whilst investing in equities (stocks and shares) can possess significant risk, the majority of investment bonds are comparatively secure, with volatility usually being less of an issue. The agreement means that investors receive a fixed return (in the form of interest) plus the initial sum at the end of the term, also known as maturity. That is, of course, unless the company gets into trouble and goes bust.

However, the security of bonds lies in the fact that the initial lending of money will have allowed the company to expand its business; paying off the debt should be less traumatic. And, if things do go wrong, bond holders stand in front of equity holders in the creditor’s queue.

As we approach RIO+20, concerns about sustainability are growing. So, what about sustainable or ethical bonds? As with all kinds of investment, it is possible to invest in bonds issued by those  companies who are active in the pursuit of sustainability, or by governments raising capital for particular projects. Climate change is a big area here, and “green bonds” is a commonly used term.

The OECD called for an increase in green bonds in May 2011 in a report entitled Towards Green Growth and said, “The market size for all green bond issuances to date is approximately USD 11 billion (with USD 1.9 billion issued by the World Bank alone), a drop in the ocean (0.012%) of the capital held in the global bond markets, estimated to be worth USD 91 trillion globally”.

More recently, Angel Gurría, OECD secretary-general, said in a press statement, “Governments and the financial industry need to ensure that attractive investment opportunities come through the pipeline by providing risk mitigation tools to cover regulatory uncertainty and issuing financing vehicles such as green bonds”.

He made specific reference to the UK’s Green Investment Bank as an example of a government project that helps “structure products and boost investment in instruments such as energy efficiency-backed bonds”.

Our new Guide to Sustainable Investment is a good place to get a firm grounding in some of the considerations for more responsible investment practices.

YourEthicalMoney.org offers a list of ethical bond funds, which gives an idea of the scope available.

But because of the large number of bond products on the market, and the complexity surrounding the different classes and risk levels available.

John Ditchfield, who is writing an upcoming feature on this topic for B&GT, agrees with the complexity and adds, “In many ways, corporate bonds should be ideal assets for retail private investors because they are lower risk than equity based investments, however, over the past five years many [bond] funds have delivered poor returns with high volatility. Of greater interest to me recently is the option for investor to buy bonds directly into social housing for example”.

To get to grips with sustainable bond options, we encourage you to seek advice from a professional—fill in our online form, and we’ll put you in touch with a specialist.

Further reading:

What is green investment?

The Guide to Sustainable Investment