Invest like THE BEST: What are bonds, complete explanation

Bonds as a Tradable Form of Debt

A bond is essentially a loan that can be traded. It's a tradable chunk of debt.
Unlike a simple loan, a bond can be bought and sold in the market.
Bonds are issued by companies, agencies, and governments.
Some unusual bonds are backed by specific cash flows, such as music royalties (e.g., "Bieber bonds").

How Bond Returns Work

The issuer borrows money by issuing a bond.
The bond has a coupon, a fixed interest rate paid to the bondholder.
The interest rate is determined by the issuer's credit risk. Riskier issuers pay higher rates.
The rate is the government's risk-free borrowing rate plus a credit spread based on the issuer's risk.
Credit ratings (e.g., AAA, BB, junk bonds) reflect the risk level. Higher ratings mean lower risk and lower credit spreads.
Investors trade off the chance of getting their money back against the return.

Maturity: Bonds have an issue date (birthday) and a maturity date (death). The bond's face value is repaid on the maturity date.
Price: The price of a bond can fluctuate, but it's always worth 100 at maturity.
Sequencing risk is the risk of drawing from a portfolio that crashes early in retirement, impacting its longevity.
Duration: The sensitivity of a bond's price to interest rate changes. Longer-term bonds are more sensitive.
Convexity: The price of a bond doesn't fall as much as expected when interest rates rise and increases more than expected when rates fall, improving the risk/reward. Government bonds typically have positive convexity.
An inverted yield curve (short-term rates higher than long-term rates) is often seen as a recession indicator.
Bond prices have a clean price (without accrued interest) and a dirty price (including accrued interest since the last payment).
Bonds can be purchased through brokers, and their availability is increasing as people realize their value in cash flow planning.

Bond funds hold portfolios of bonds that are continuously changed. This introduces uncertainty about the fund's duration, income, and risk.
Bond funds are sensitive to interest rate changes, but long-term returns are mostly based on the income (yield) component.
The benefit of a bond is the certainty of returns if held to maturity. This certainty is removed with bond funds.
Target date funds reduce risk over time towards a target retirement date, but a 100% equity or highly diversified international approach might work better long term.
The 60/40 portfolio allocation may not be as effective in the long term due to higher correlation between bonds and stocks over longer periods.
Many workplace pension plans use these strategies by default, potentially penalizing returns.
Companies are incentivized to keep people in funds, even if they are not the best option for the client, to generate fees.
International equity can provide a better hedge due to currency devaluation when there is inflation.

Governments issue bonds to fund spending, but too much issuance, particularly during high inflation, can cause interest rate hikes and currency devaluation.
The UK government's actions in 2022 caused a significant rise in yields and mortgage costs because of excessive and poorly communicated debt issuance.
Municipal bonds are used in the US and Canada to fund local projects like libraries, fire services, etc., offering tax advantages and community investment.

These funds are ultra-safe investments that aim to maintain a value of £1, paying interest based on short-term rates.
They are used to park money temporarily for taxes or short-term expenses and provide a better return than a typical savings account.
They invest in short-term government debt, commercial paper, and deposits with banks.
The returns are linked to short-term rates and provide very high liquidity, but they carry risks including the possibility of default of commercial paper, as happened with the Prime fund in 2008.
Central banks know this risk and will likely take action to restore market confidence if there is a problem.
UK government bonds are very safe, and governments are not likely to default, although they might pay a "moron premium" for irresponsible debt management.
Money market funds invest in debt with an average maturity of 30 days, making them very low risk. Their returns track the SONIA rate, which is linked to the Bank of England's rate.
They allow quick access to rate adjustments.
They are very liquid, with cash payments every month, which can be reinvested.

Taxation

In the UK, capital gains from gilts are not taxed, but coupon income is taxed.

Bond Ladders

A bond ladder involves purchasing bonds with different maturity dates to provide a steady cash flow, especially during retirement.

Bonds at Different Life Stages

Bonds can be used at different life stages to save for houses (20s), children's expenses (30s, 40s), and retirement (60s).
Municipal bonds can transform communities by funding local projects.