In part 2 of our educational series, we’re talking about bonds and how you could earn steady returns by lending money to large companies and governments.
The basics, in 60 seconds.
It’s best to think of bonds as a really formal IOU to the government or a big company. You are lending them money collecting interest in return.
Let’s say you have some cash in your current account and decide to lend some of it to a company or government so they can invest in important projects like hospitals, roads, or new factories. They will eventually return the full amount with an additional amount, interest, to compensate you for the risk you’re taking by giving your money to someone else. In many cases, borrowers will even hand out an extra payment called a coupon, to incentivise people to lend them money.
As an investor, you should expect a higher interest rate if there is a chance the company may be unable to pay you back. You want to get paid more for stomaching the risk of not possibly getting your cash back. This is why a UK government bond will offer a lower interest rate than a risky company in a foreign country that is on the verge of bankruptcy.
All else equal, bonds are safer than stocks because you are first in the queue to recover any losses if a company goes bankrupt. Also, bonds offer more predictable income (coupons and interest), whereas dividends from stock are never guaranteed. Generally, if you’re cautious about your investments, you want to have your money invested in a more bonds than stocks.
A practical example:
You are giving your friend George a £100 and expect to receive £105 back in a year’s time. You want receive your original £100 back but also expecting an additional £5 to compensate you for the risk that George might be unable to pay you back. Now, George has a stellar reputation and has gained your trust over the years so you’re giving him a lower interest rate than someone who has a history of running away with people’s money.
After 1 year, George pays you back £105 and thanks you for the loan. You received the original £100 back and just made an extra fiver in profit. That’s right, bonds are that simple.
This explainer article is part of our ongoing education series to inform and educate the next generation of investors by explaining key investment topics. To learn more about Fountain, check us out online.