What is a bond?

The Wokingham Paper - - NEWS - With Tim Em­ble­ton from Time Fi­nan­cial Plan­ning TIM EM­BLE­TON IN­VEST­MENTS – THE VALUE OF UNITS CAN FALL AS WELL AS RISE, AND YOU MAY NOT GET BACK ALL YOUR ORIG­I­NAL IN­VEST­MENT Time Fi­nan­cial Plan­ning Lim­ited is an ap­pointed rep­re­sen­ta­tive of The On-Line Part

IN THE sec­ond part of this month’s series of ar­ti­cles on in­vest­ing and cre­at­ing the ideal port­fo­lio, I’m go­ing to an­swer a ques­tion I’m fre­quently asked which is ‘What is a bond?’ Bonds are often con­fused with the fixed-rate bonds that you would get from a bank or build­ing so­ci­ety. When I ask some­one if they know what a bond is they often say ‘no’ or ‘oh yeah, isn’t that one of those things where you tie your money up for three years.’ The an­swer is ‘sim­i­lar, but not quite the same’. A bond is es­sen­tially a loan to some­one and is very sim­i­lar to a loan to a gov­ern­ment, known as a gilt, which we’ll ex­am­ine in a fu­ture piece. With bonds and gilts all you’re do­ing is giv­ing the money to some­body else to use and in re­turn they’re giv­ing you some in­ter­est. Be­cause there is a lit­tle bit of risk in­volved be­cause they might not pay us back we would ex­pect a higher in­ter­est rate on bonds then we would on cash. How­ever, we’re also tak­ing a risk that in­ter­est rates might rise which would mean the in­ter­est rate I’m get­ting from the bond is less valu­able. How­ever, bonds are more se­cure than shares be­cause in the event of the fail­ure of the en­tity, bond­hold­ers - the debtors - must be paid back be­fore share­hold­ers. It’s also im­por­tant to look at du­ra­tion. If the du­ra­tion of a bond fund is very long it’s go­ing to be much more sen­si­tive to in­ter­est rate changes so its volatil­ity is go­ing to be higher. We would often rec­om­mend the use of shorter du­ra­tion bond funds for clients that are look­ing to diver­sify or re­duce risk. The key here is that while bonds should be a part of some­one’s port­fo­lio it’s cru­cial that the right ones are cho­sen. These days it’s easy to look up the per­for­mance of bond funds on­line and it’s tempt­ing to just pick the high­est per­form­ing one. But what peo­ple often don’t re­alise is that po­ten­tially they’ve picked some­thing that’s got a re­ally long du­ra­tion. It might have per­formed well up un­til now, but what hap­pens when in­ter­est rates go up? It might sud­denly be­come the worst per­form­ing bond fund. It might also be a junk bond fund or a high yield bond fund and these tend to be­have much more like eq­ui­ties. So, they’re not re­ally do­ing the job of damp­en­ing or re­duc­ing risk that your port­fo­lio needs. As you can see, tak­ing ap­pro­pri­ate fi­nan­cial ad­vice is im­por­tant to en­sure you don’t end up with the wrong prod­uct. Next week we’re go­ing to look at prop­erty funds and how we can add ex­po­sure to the prop­erty mar­ket to your port­fo­lio with­out you hav­ing to phys­i­cally buy bricks and mor­tar.

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