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I have an ISA that has matured recently, and am now looking to reinvest that balance elsewhere. Given that most of the ways I usually save (current/ savings accounts, regular savers, ISAs, etc) aren't really offering great interest rates at the moment, I am starting to look into investment bonds for the first time.

I have absolutely no idea what I need to take into consideration when looking at bonds... as I understand, they are generally considered to be 'higher risk' investments than the usual ways of saving that I've mentioned above. Why is this? What makes the risks higher? What risks do I need to be aware of if I do go ahead and invest in a bond?

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All bonds carry a risk of default, which means that it's possible that you can lose your principal investment in addition to potentially not getting the interest payments that you expect. Bonds (in the US anyway) are graded, so you can manage this risk somewhat by taking higher quality bonds, i.e. in companies or governments that are considered more creditworthy.

Regular bank savings (again specific to the US) are insured by FDIC, so even if your bank goes bust, the US Government is backing them up to some limit. That makes such accounts less risky. There's generally no insurance on a bond, even if it is issued by a government entity.

If you do your homework on the bond rating system and choose bonds in a rating band where you're comfortable, this could be a good option for you. You'll find, however, that the bond market also "knows" that the interest rates are generally low, so be ware that higher interest issues are usually coming from less creditworthy (and therefore more risky) issuers.

EDIT Here's some additional information based on the follow-up question in the comment. When you buy a bond you are actually making a loan to the issuer. They will pay you interest over the lifetime of the bond and then return your principal at the end of the term. (Verify this payment schedule - This is typical, but you should be sure that whatever you're buying works like this.)

This is not an investment in the value of the issuer itself like you would be making if you bought stock. With stock you are taking an ownership share in the company. This might entitle you to dividends if the company pays them, but otherwise your investment value on a stock will be tied to the performance of the company. With the bond, the company might be in decline but the bond still a good investment so long as the company doesn't decline so much that they cannot pay their debts.

Also, bonds can be issued by governments, but governments do not sell stock. (An "ownership share of the government" would not make sense.) This may be the so-called sovereign debt if issued by a sovereign government or it may be local (we call it municipal here in the US) debt issued by a subordinate level of government.

Bonds are a little bit like stock in the sense that there's a secondary market for them. That means that if you get partway through the length of the bond and don't want to hold it, you can sell the bond to someone else. Of course, it will be harder to sell a bond later if the company becomes insolvent or if the interest rates go up between when you buy and when you sell. Depending on these market factors, you might end up with a capital gain or capital loss (meaning you get more or less than the principal that you put into the bond) at the time of a sale.

  • Sorry, probably should have said- I live in the UK. The particular bond I was looking at was with Halifax (which was where the ISA I had was). I don't know if 'investment bond' is the correct term for this? If I was to open it, would I be investing in Halifax as a bank (i.e. the value of the bank itself), or am I giving them a lump sum for them to invest in stocks/ shares/ whatever, with them promising to pay me interest for the use of that capital? If it's the latter, then does that mean that I am guaranteed that interest rate no matter whether how they invest my capital pays well? – Noble-Surfer Oct 1 '15 at 11:39
  • I updated my answer to address some of the issues that you raised in your comment @someone2088. – user32479 Oct 1 '15 at 12:27
  • That's a really helpful explanation- thanks very much! So, following on from what you've said in the last paragraph- assuming that I don't sell the bond, but hold onto it for the entire duration of its term, then provided the bank/ building society that sold me the bond haven't gone bust, the return I will get would be the value of my initial investment + the accumulated interest for that duration of time? – Noble-Surfer Oct 1 '15 at 13:35
  • @someone2088- Yes. your return is the accumulated interest, either paid incrementally or at maturity of the bond. The bond will mature at a stated value. Whether you bought the bond at a discount or premium (less or more than maturity value) will also affect the "total return". – michael Oct 1 '15 at 14:00
  • Sorry- I don't understand what you mean by buying the bond at a discount or premium? As I understand, I will buy the bond for a value of my choosing- i.e. I give the bank a sum of £X, and they give me a certificate stating that I have opened/ bought a bond at that value, and the agreed interest rate. In that respect the bond will always be 'purchased' at a value that is less than the maturity value won't it? I can't think why anyone would buy a bond at a value greater than its expected maturity value... – Noble-Surfer Oct 1 '15 at 14:46
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First off, I do not recommend buying individual bonds yourself. Instead buy a bond fund (ETF or mutual fund). That way you get some diversification.

The risk-reward ratio will be evident in what you find to invest in. Junk bond funds pay the highest rates. Treasury bond funds pay the lowest. So you have to ask yourself how comfortable are you with risk?

Buy the funds that pay the highest rate but still let you sleep at night.

  • For decades now, the long-term average rate of return of junk bonds has not actually exceeded that of investment-grade bonds. During bear markets, junk bonds behave a lot like stocks -- many go down by 30% - 80%. Their interest rate premium during "good times" barely makes up for their default risk during bad times. – Jasper Oct 1 '15 at 3:21

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