The term generally refers to bonds on which the holder receives a pre-determined fixed rate of interest, although it also includes index-linked bonds where the coupon or interest payment is linked to inflation. It is generally used to describe an asset class that includes not only government bonds (gilts) but also corporate bonds, debentures and preference shares.
A bond is a form of IOU. It is an agreement under which a sum of money (the principal) is repaid to the bondholder after a specified period of time (on maturity or redemption), during which an interest payment or ‘coupon’ is usually also paid. Bonds are also referred to as fixed interest assets, although in the case of ‘index-linked’ bonds, the interest increases in line with the retail price index (RPI) as does the principal.
Bonds are issued by companies, and by local and central governments. Central government bonds are referred to as ‘gilt edged’ (the certificates often had gilt edging) or just ‘gilts’ and are the least risky of investments.
Government bonds (gilts)
Gilts are grouped according to their ‘lives’: that is, the number of years until the redemption date when the bond matures. ‘Shorts’ are those bonds with redemption dates falling within the next five years. Medium dated have redemption dates between five and fifteen years ahead. ‘Longs’ are those with lives of more than 15 years. ‘Undated’ gilts are never redeemed. Index-linked gilts have both the coupon and principal linked to RPI. Government bonds are issued in units of £100.
Bonds are traded in a similar way to shares, although the prices movements tend to be much smaller. The expected level of bank base rates in the future is the main factor that determines the prices at which bonds are traded. If interest rates are expected to rise, then the market prices of bonds will fall.
A corporate bond is an IOU issued by a company or organisation in exchange for a loan. Bondholders receive interest at a fixed rate and the promise that their capital will be repaid at a certain date in the future. Corporate bonds are bought and sold through the market in the same way as government bonds (gilts).
Corporate bonds are given ratings according to their quality (in effect the financial health of the issuing company). The interest payable (or the discount at which they are offered) will reflect this quality rating. The bonds with the highest risk (sometimes referred to as ‘junk bonds’) will offer the highest rates of interest.
A loan raised by a company, paying a fixed rate of interest and which is secured against some or all of the assets of the company. They may be secured by a floating charge on the company's assets or they may be tied to specific, named assets.
Debenture interest has to be paid by a company whether it makes a profit or not - if the debenture holders do not get paid they can have specific assets seized or appoint a receiver or liquidator.
Debentures are a form of financial asset or security and can be traded. They are similar to bonds, but with an added level of security.
Deep discount bonds
These are bonds which provide very little or no interest and instead are offered at a substantial discount to their redemption value. This discount compensates investors for the loss of interest.
Index-linking refers to linking some aspect of a financial product to the Retail Price Index (RPI), and applies to some gilts and National Savings products.
For example, there are index-linked National Savings Certificates, where the rate of interest is, say, RPI plus 2.5% or whatever. Since National Savings Certificates are usually issued in both index-linked and non-linked forms covering the same period (typically 2 to 5 years), it is easy to compare the rates offered and so calculate the expected RPI over that period. In recent years, the returns from index-linked and normal National Savings Certificates have turned out to be fairly similar, with possibly the index-linked having a small advantage.
Permanent Interest Bearing Shares (PIBs)
Issued by major building societies, these offer investors a fixed income paid twice yearly, after deducting basic rate tax. Traded on the London Stock Exchange, their market value changes in response to interest rates. PIBs are not redeemable, and are similar to, but riskier than, undated government stocks. With a total market of less than £1billion, PIBs are less liquid than gilts.
Preference shares are a class of share that pay a fixed dividend, and entitle the holders to receive their dividends in preference to any dividends paid to ordinary shareholders, and who rank ahead of ordinary shareholders in the event of the company being liquidated. Preference shareholders may have limited voting rights in general meetings of the company.
Preference shares are sometimes redeemable or capable of being converted into ordinary shares.
Fixed interest returns
Fixed interest investments usually provide both an income stream and a capital sum on redemption. The income stream depends on the coupon, which is the annual interest payment based on the nominal value of the bond. For example, Treasury 5% 08 is a government bond that matures in 2008 and pays 5% on the nominal value – which gives an income of £5 per year for every £100 nominal value. On maturity, bondholders will receive the nominal amount of £100 for every 100 bonds that they own. That bond is currently priced in the market at £101.12. If you buy 100 bonds today, you will pay £101.12. You will receive £5 per year income, which represents an interest yield of 4.94% (£5 as a percentage of £101.12). If you keep the bond until redemption in 2008 you will also receive £100, which is slightly less than you paid. We need to take both the interest yield and the redemption value into account to calculate the effective rate of return, which is called the redemption yield.
This is in effect the annual rate of return on an investment that has either an income plus a lump sum payable on redemption, or simply provides a lump sum on redemption. It takes account of the amounts paid and the timing of the payments to calculate the effective yield (rate of return) based on the current market price. It is quoted together with the income yield for all government stocks (gilts) that have a redemption date.
The example we've just used (Treasury 5% 08) has a redemption yield of 4.6%.
Buying bonds and other fixed interest investments
Gilts can be bought through any stockbroker and also through the DMO retail operation. National Savings products can be bought through a Post Office or direct by post or online from National Savings and Investment (NS&I).
Corporate bonds, preference shares and debentures are bought and sold through a stockbroker. There are also managed funds and exchange traded funds that invest in corporate bonds, and naturally provide a higher degree of diversification than most investors could achieve directly. The management costs for bond funds tend to be lower than for equities.
|9 October, 2008 © 2008 K.R.Wade and Co Ltd|