How to Buy Bonds in the UK

Bonds are a popular debt instrument that can offer capital gains, steady income or potential to profit from speculation. Here’s what you need to know about buying bonds in the U.K.

Bonds are a popular investment security for many traders and investors. While they may not offer as high volatility as stocks, they nevertheless play an important role in an investment portfolio.

There are many reasons to invest in bonds. Investors can use bonds to diversify an existing portfolio of stock holdings; in fact, the oft-quote rule of thumb for a balanced portfolio is “60% equities, 40% bonds”. 

Another reason is to build an income stream, as bonds offer regular interest and dividend payouts. And for those pursuing a more active investment style, bonds can be traded as a financial asset, with the potential to earn a profit (or correspondingly, a loss – more on this later).

In this article we will be taking a closer look at investing in bonds, including what you need to know about buying bonds in the U.K.

Understanding bonds

What are bonds?

In basic terms, bonds are a type of I.O.U, where an investor “lends” money to the issuer of the bond. In return the issuer promises to pay back the principal sum to the investor, with interest, over a pre-defined duration – ranging from months to several years or even decades.

Bonds offer regular dividends known as coupons, rendering them fixed-income instruments. While fixed-rate coupons are the conventional structure, some modern bonds also offer variable-rate coupons.

Besides the terms for fixed- or variable-rate dividend payments, bond details should also include the end date of the bond – that’s when the principal of the loan is due to be repaid to the investor.

How do bonds work?

Bonds are issued as a means to raise funds from the public. They are used by governmental bodies and corporate entities alike.

The funds pooled together from investors (aka bondholders) are put towards various projects that generate economic value, such as business growth, in the case of corporate bonds.

Meanwhile, government bonds serve various purposes, ranging from construction of public infrastructure to funding deficits in budgets.

In either case, when you invest in a bond, you are essentially making a loan to a company or government. You will then receive regular interest payments up until the bond matures, upon which you will get back the principal amount invested.

Here are some key terms to remember.

• Maturity: the length of time until a bond expires and makes its final payment.
• Principal: also known as ‘face value’, the principal is the amount the bond agrees to pay the bondholder, excluding coupons. Generally paid as a lump sum upon bond maturity.
• Bond price: the issue price of a bond. In theory, this should equal the bond’s face value. However, the price of a bond on the secondary market – traded after it’s been issued – can fluctuate due to various factors.
• Coupon dates: the dates on which the bond issuer is required to pay the coupon. The patent schedule can range from annually, semi-annually, quarterly or monthly.
• Coupon rate: basically, the interest rate paid on the bond. For example, if the face value of the bond is S$10,000, and it pays out S$500 per year, the coupon rate is 5% per annum.
• Secured/unsecured: just like other types of debt instruments, bonds can be secured (i.e.,) or unsecured. In the former, investors are entitled to collateral in case of default.
• Risk: the likelihood of the issuer defaulting on their bond repayment; generally, the higher the interest rate, the riskier the bond (and vice versa). Bonds are rated by rating agencies such as Moody’s or Standard & Poor’s, with the highest rating (lowest risk) being AAA, followed by AA, A, BBB and so on.

What types of bonds are there?

There are five primary categories of bonds, as follows:

Corporate bonds	Issued by companies. Corporate entities may choose to issue bonds in lieu of taking bank loans for debt financing, so as to access more favourable terms and lower interest rates.
Municipal bonds	Bonds issued by states and municipalities. To attract investors, some municipal bonds offer tax-free dividend payments.
Government bonds	Issued by government bodies, such as the HM Treasury in the U.K. Government bonds are known as gilts in the U.K.
Agency bonds	These are issued by government-affiliated organisations.
Foreign bonds	Bonds issued in a domestic market by a foreign entity. Priced in the domestic market’s currency, it is commonly used to raise capital.

Trading bonds in the UK

As mentioned, U.K. government bonds are known as gilts. Investors can invest in bonds in the U.K. via the following methods.

• Direct purchase from the U.K. government, primarily the HM Debt Management Office or authorised agents. Individual bonds are also available for purchase on the London Stock Exchange.
• Investing in bond funds, usually in the form of bond ETFs, which invest in government bonds using the money pooled from investors. Bond funds offer regular income through dividends.
• Investing in index-linked gilts, which work the same way as index funds. An index-linked gilt (aka government bond ETF) tracks the value of glints and offers returns in tandem. They can be purchased through trading accounts.

Ways to invest in or trade bonds

#1 Buy-and-hold

This method entails choosing bonds and holding them to maturity, maximising the income reaped from the bond.

A variation on this method is known as “laddering”, where you buy several bonds, each with different maturity dates. Laddering allows you to smoothen out interest rate swings while enjoying steady income.

#2 Barbelling

In barbelling, the idea is to buy mainly long- and short-term bonds, with a few medium-term ones. This combines higher yields from long-term bonds, and flexibility from short-term bonds.

Due to interest-rate risk (bond values tend to drop when interest rates rise), this method is best employed when interest rates are relatively stable.

#3 Swapping

Swapping entails the selling off poor-performing bonds and using the proceeds to purchase another (hopefully) better performing one. This has the advantage of allowing you to receive – where applicable – tax write-offs for the loss, while removing under-performing bonds that are not likely to recover anytime soon.

#4 Trading bond futures

Bond futures allow speculation on the price movement of bonds. A trader enters into an agreement to buy or sell a bond futures contract at a date in the future.

Depending on the price of the bond at the time the contract expires, and the trade made by the trader, a profit or loss may be made.

Trading bond futures can generate substantial profits (or losses) from bond markets which are traditionally low volatility. This is because prices can fluctuate significantly over time due changing interest rates, market demand, economic conditions and other factors.

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