A guide to investing in bonds

Q I am a novice investor and wish to start by investing in local and foreign bonds. I am aware that you can also invest in funds that hold hundreds of different bonds. Bearing in mind I have no practical experience of bonds, can you summarise the main features of these investment vehicles and how government bonds differ from corporate bonds?

A A simple way to reap the rewards that bonds can offer is to invest in fixed interest (bond) funds rather than individual securities. Pooled funds, often referred to as collective investment schemes, allow you to access the experience, skills and research capabilities of a professional fund manager, and you can also hold a far greater range of bonds than you could acting alone.

Before you decide whether bonds are right for you, it is important to understand what they are and how they work. Put simply, a bond represents a loan made by you to a government or corporation.

In return for your money, the borrower agrees to pay you a specified rate of interest and repay the amount of the loan at the end of a pre-agreed period, otherwise known as the maturity date.

There are two main types of bonds: government bonds and corporate bonds. As the name suggests, government bonds are those issued by sovereign governments. They are traditionally considered to be safer than corporate bonds as they are backed by government guarantees and, because of this, returns have not historically been as high.

Corporate bonds are issued by a wide range of companies, often to finance expansion. There is a wide range of corporate bonds on offer and they can be an attractive choice for those who are happy to take a higher level of risk in exchange for potentially higher returns.

Between a bond being issued and its maturity, its value can change in response to a number of factors. Interest rates can have a big effect on bond prices - generally when interest rates rise, the value of a bond decreases and when rates decline, bond prices tend to rise.

Not all bonds react in the same way, though, to interest rate fluctuations. Lower quality corporate bonds, for example, tend to be the least sensitive to interest rate changes, while government bonds are the most sensitive.

The value of a bond also depends on the time remaining before the debtor must pay back the principal amount, that is, bonds with longer maturities tend to have higher yields. This is to compensate the investor for the greater length of time for which their money is tied up and subjected to fluctuations in interest rates.

Finally, the creditworthiness of the issuer, or the likelihood that it will default on the loan, is another important factor. The risk of investing in a bond is usually determined by a credit rating issued by a rating agency such as Standard & Poor's.

These ratings are based on an independent assessment of a company's financial status, and start at AAA for the highest quality down to C for lower quality, high-yield bonds. They can help you work out the degree to which your capital is at risk and give an indication of a bond's quality.

It is unusual for an investmentgraded bond issuer not to be able to meet its repayment obligations and as additional security, if a company were to find itself in trouble, its fixed interest creditors would actually take preference over its equity shareholders.

Mark Hollingsworth is the director of Hollingsworth International Financial Services - licensed by the MFSA to provide investment services under the Investment Services Act 1994 (IS/32457). Address any financial questions to: Mark Hollingsworth, c/o The Sunday Times, PO Box 328, Valletta CMR 01. Alternatively, he can be contacted on 2131-6298/9984-2614 (office hours) or e-mail mh@hollingsworth-int.com

Past performance is no guide to the future and, except where amounts are guaranteed, the price of your investments (and the currency in which it is denominated) may fall as well as rise. Your personal tax situation will depend on residence. Always consult a professional adviser. This article does not intend to give investment advice and its contents should not be construed as such. Readers are encouraged to seek professional advice on their personal financial situation.