Bonds are issued by governments, companies and other borrowers to raise money for a certain period of time. In return, the borrower pays the bond holder a regular income over the lifetime of the bond and promises to repay the lender when the bond matures.
Bond funds, also known as fixed income funds, can invest in bonds issued by a range of different borrowers. Some funds invest in government bond markets, which can be considered lower risk than equities and other types of bonds. Other funds concentrate on higher risk bonds such as corporate bonds or emerging market debt, which offer a higher income yield, but higher risk to capital.
Many bond funds will focus on just one market and/or on just one type of bond. However, some bond funds can invest more flexibly, either across a range of different types of bonds and/or across regional and global markets.
Government bond funds
Government bonds are deemed highly creditworthy. Funds investing in government bonds can therefore provide an attractive option for investors looking to have lower risk investments in their portfolio while still earning an income.
Some government bond funds can focus on just one market, such as UK Gilts or US Treasuries, or on a region, such as European bonds. You can also choose a global bond fund to spread risk and diversify sources of return.
Corporate bond funds
Corporate bonds are issued by companies looking to raise financing. Corporate bonds typically pay higher yields to lenders than government bonds as most companies are deemed to have a higher risk of default (missing income payments or not repaying lenders) than governments.
Bonds issued by the most financially strong companies are known as investment grade bonds. Some corporate bond funds will focus only on investment grade bonds. They may invest in a single market, such as the UK, regionally, or globally.
Bonds issued by companies, deemed to have a higher risk of default, are given ratings below investment grade. These bonds are known as high yield bonds. High yield bond funds can be attractive, particularly for income seekers, as they pay a high income yield. However, they also carry a higher risk to capital.
Emerging market bond funds
Emerging market bonds can be issued by governments of developing countries and by companies based in emerging markets.
Emerging market sovereign and corporate borrowers are usually deemed by credit rating agencies and investors to carry more risk than borrowers from developed markets. However, funds investing in emerging market bonds can potentially provide a higher income yields and more attractive long-term prospects for capital growth as emerging market creditworthiness improves.
Investments in emerging markets may involve a higher element of risk due to political and economic instability and underdeveloped markets and systems.
Strategic and opportunistic bond funds
These bond funds can take a global view in search of the most attractive markets and bonds, investing flexibly in government, corporate and emerging market bonds. They can adapt their fixed income allocations and portfolio positioning depending on the prevailing economic and market environment, aiming for positive annual returns and a low level of volatility
The price/interest rate relationship
When new bonds are issued, they typically carry coupon rates at or close to the prevailing market interest rate. Interest rates and bond prices have what's called an "inverse relationship" - meaning, when one goes up, the other goes down.
When interest rates rise, a bondholder is holding Bond A, which is yielding 4%. The central bank raises interest rates to 5%. Bank account interest rates increase AND future bond issuances will have higher coupons. Bond A looks less attractive, and the bondholder sells. Bond prices fall to a point at which the yield becomes attractive enough to appeal to new buyers.
When interest rates fall, a bondholder is holding Bond A, which has a 4% coupon. The central bank cuts interest rates to 3%. Bank account interest rates fall AND future bond issuances will have lower coupons. Bond A looks more attractive and is sought by investors. Bond prices rise and yields fall.