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What are Bonds?

A bond is effectively a loan or IOU to a government, local authority or company they are known as the issuer. In return for the loan the issuer promises to pay you a set rate of interest for the life of the bond. They will repay the face value of the bond known as the principal when it closes or matures.

Once a bond is issued, it can be bought and sold.

Bonds have many types:

  • government securities and foreign government bonds
  • sub-sovereign bonds
  • supranational and quasi-government bonds
  • corporate bonds
  • collateralised securities

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How are Bonds calculated?

Bonds have a nominal value which is usually 100 (at par). This sum will be returned to the investor when the bond matures (when it is finished). However, bonds are traded on the bond market. That means the price you actually pay for a bond might be either more or less than 100 (above or below par). Here"s why:

  • A bond is dependent on the base interest rate. Even if the bond itself has a fixed interest rate (say, 5%) and the base interest rate falls below that, then it is probable that the market price of the bond will rise because 5% will look like a good yield. Therefore, the bond price could increase to around 120.
  • This can also happen reversely if interest rates are raised then the fixed rate of the bond might look less attractive and the price could therefore go down to below 100.
  • The rate of inflation can also affect the attractiveness of a bond if inflation rises then the interest rate on the bond could look less appealing.
  • The market price of a bond could also fall because a ratings agency decides that a company"s (or government"s) bond is no longer worthy of a high rating. The reverse of this could also happen. Ratings agencies are constantly monitoring companies and governments to see that they are worthy of their rating (for example, the UK currently has a triple A sovereign rating with Standard & Poor"s, but if the economy suffers greatly then it could fall to a lower rating).

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What is the Difference between Bonds and Shares?

Bonds can be exchanged (bought and sold) in the market like shares, and their prices can vary from one day to the next. But they are not the same product, even though they do have many similarities. Why? Buying stocks or shares from a company means you actually take ownership of a portion of that company. A bond is merely a loan (or IOU) to that company.

Bonds are seen as being generally less risky than having a share in a company this is because you are given a fixed interest rate and regular returns over the lifespan of the bond. However, that does not mean that bonds are risk-free.

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What should I Consider when Investing in Bonds?

Before investing in bonds, you should investigate some of the following key factors:

  • When is the bond"s maturity?
  • How is the credit quality (of the issuer)
  • What is the interest rate?
  • How much does this cost?
  • What is the yield?
  • Are there any tax features?
  • Market fluctuations
  • What is the risk?

Go over these with a financial adviser and make sure you are clear on each for your personal case. Most advisers recommend a diversified investment portfolio, and generally bonds are a viewed as providing a steady income. Therefore, it may well be that you will receive a recommendation to invest in some bonds. However it is important to understand the product before you invest!

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What are the Benefits of Bonds?

Each bond type carries its own benefits such as the relative security you receive when lending money to a "safe" entity such as a government but the main benefit is that you generally get a stable regular income.

They are fairly "low risk" compared to other types of investment. An aspect that attracts many risk-shy investors is that you will at least receive the nominal value of the bond at maturity. That said bonds are not the best place to head for capital growth.

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Buying and Selling Bonds

You can buy bonds via a bond broker they are registered officially to buy and sell bonds for individual and institutional investors. In the UK a bond broker should be regulated by the Financial Services Authority and might be independent, with brokerage firms or with a bank. Depending on what level of assistance and level of service is up to you there are various ones to choose from.

  • Full-Service Brokers

Full-service brokers offer clients assistance and help to reach their investment goals. They will recommend investment avenues and research areas on your behalf. They may also execute buying and selling of bonds for your portfolio. The high level of assistance may carry extra fees.

  • Discount Brokers

Discount brokers offer to execute buying and selling for their clients but won"t offer extras like advice on investments. They are likely to buy bonds from full-service brokers or issuers and resell them to you. There may be charges for their services.

  • Online Brokers

Online brokers offer value deals for investors who want to invest directly. They might allow you to compare bond offers across many bond dealers and place online orders. The client can open an online account through which they can buy and sell.

  • Banks

Many banks offer a bond investment service.

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What are the Risks of Bonds?

The main risk of bonds is that the company you have lent money to is unable to repay the interest or the full money back at the end of the bond term. This could happen if the company goes bust or loses large amounts of profit.

With regards to government bonds, this risk is not as great because it is pretty unlikely that a government can go bust. However, it has been known to happen in some countries that the government has been unable to repay. Note that government bonds will generally pay a lower interest rate because of their lower risk perception.

You can try to take steps to manage your risk using the credit rating of a company is one way. For instance, the higher a credit rating of a company, the less risk is posed to your money. Try to think of this as if roles are reversed you are now the bank assessing whether the loan applicant is suitable to lend to!

You can see the latest company credit ratings and country sovereign ratings at the main rating agency websites: Fitch Ratings, Standard & Poor"s and Moody"s Investor Service. Note that you may have to register a profile on these sites in order to access all areas. However, they are a very useful resource so it might be worth registering.

Because bonds can be bought and sold (similarly to stocks and shares) on the market, their prices can vary from one day to the next. However, if you hold the bond until it matures, any such fluctuations will not affect what money you would get back.

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Bond Types

Below you will see a guide to the main Bond types.

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Government Bonds (or Gilts)

Government bonds, as the name suggests, are bonds which are issued by governments. In Europe, they are sometimes referred to as sovereign bonds. In the UK, government bonds are also called gilts. For the purpose of this guide, we will now refer to them as gilts.

Gilts are generally thought of as being the best type of bond because they are backed by a central government which means they are less risky than other bond types. However, this is not the case when you consider emerging or "developing" country government bonds here, risk is still a high factor. Gilts are the most popular type of bond for individual investors.

The government promises to pay back the full amount (termed as the principle) at a specified date plus interest (termed as the coupon). Gilts are issued at par or 100p but traded on the open market. This allows you to sell the gilt before its redemption date. However, selling before redemption means you might not get back your initial investment.

You can buy gilts below par and keep them until the redemption date to make a profit. Similarly you could buy gilts above par and make a loss.

What are the Gilt types?

There are three main types of gilts:

  • Gilt-edged Security

This is the oldest and most traditional of the gilt types. It pays out half the annual coupon every 6 months until maturity date. At this point the final coupon payment and the initial investment are paid to the investor in full.

  • Index-linked Gilt

A gilt type which offers an inflation-proof fixed return. Here, there is an adjustment made to the value of coupon payments and inflation. This is calculated by the original value and any alterations in the RPI (Retail Price Index). During periods of deflation risk (such as was experienced in 2009 during the recession), it is best to steer clear of index-linked gilts.

  • Strip

This gilt type is one which is sold at a discount to the nominal value. It is sometimes called a zero-coupon bond. Gains from Strips are taxed as income on a yearly basis, and these gilts are traded separately as non-interest bearing bonds. Returns are received from an increase in capital as the bond nears maturity. Strips are considered most attractive for low-rate taxpayers who are capital rich.

Which Type is Right for Me?

When choosing a gilt type, you should consider how much capital you have to invest and in which taxpaying bracket you belong. Some are better for capital-rich investors (such as Strip gilts). Think about your outlook for inflation and interest rate.

For instance, if you think interest rates will rise, go for short- to medium- range gilts. This is because you could risk getting stuck in an investment which pays interest below that which might be offered in a deposit account. If you think deflation is on the horizon then longer-term gilts might be worth considering.

How can I Buy Gilts?

You can buy gilts from a bank or stockbroker. The advice from either one of these will be expert and ideal for newcomers to the gilts market. Alternatively, you can join a gilt fund. Joining a gilt fund means that your investment is in the hands of an expert fund manager and you can benefit from a portfolio which is diverse and a better spread of risks.

What Costs are Involved?

When buying gilts, aside from the purchase itself you will need to contend with commission charges or annual and management fees charged by gilt funds. The price of gilts will depend on the current base interest rate.

What are the Risks?

All investment types pose a risk to your capital but in many cases also a chance that you could make a good return. Gilts are viewed as being "low risk" investments. This is because they are backed by the government a body which is highly unlikely to go bust and be unable to repay their loan to you.

That said, the prices of gilts do fluctuate with the Bank of England base rate as it goes up, so does the value of gilts and vice versa. For instance, when the Bank cuts the base interest rates, Gilt prices rise. The opposite happens when the bank raises rates.

Another factor which makes gilts attractive to investors is their reaction to perceptions of future interest rates. The longer a gilt has to maturity, the more sensitive it is to changes in the interest rates. This is known as duration risk.

Gilts are traditionally attractive for capital rich investors, and those who have a clear target for their investments. For less capital rich investors, a straightforward savings account might be more suitable.

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Corporate Bonds

After gilts (or government bonds), corporate bonds are the second largest market sector in the bonds market. In Europe, corporate bond markets are growing albeit it a relatively slowed pace due to the 2009 recession.

In the US, corporate bonds are much more popular as direct individual investments than in the UK and Europe. In the UK, most individual investors choose to invest in corporate bonds via a pooled (or collective) investment fund.

What are Corporate Bonds?

In the same framework as gilts, corporate bonds are a loan or IOU but in this case issued by private and public corporations (not governments). There are various types of bonds which companies issue and they sell bonds in order to expand their business, build equipment or facilities or anything which brings the business forward. A company might also sell bonds because it needs to raise finances which it does not have.

Similarly to gilts, you buy a bond and will receive the principal on a set maturity date. Until then you will receive interest (stated) on a regular basis usually twice a year.

Where are Corporate Bonds Traded?

Most corporate bonds (as gilts) are traded in an over-the-counter (OTC) market this is not a central exchange in the UK. Instead, it is created out of many bond dealers and brokers who trade bonds electronically (or over the phone) around the world.

What are the Benefits of Corporate Bonds?

There are many reasons why an investor might choose to buy corporate bonds for their investment portfolio. These include the following:

  • Reliable income

Thanks to the regularly-paid interest, the investor knows that he/she will receive a steady income.

  • Good yields

It is generally found that corporate bonds give higher yields than some government bonds. However, this does mean that more risk is posed.

  • Security

Thanks to the ratings system all companies are given a rating based on their credit history, stability and their ability to repay loans investors can get a good judgement on where to invest. Generally it is thought that the higher the rating, the safer the investment. There"s a twist however: the lower an issuer"s rating is, the higher the interest they will pay on the bonds they issue.

What is Yield?

Yield is a key factor when investing in any type of bond. It is the tool that an investor uses in order to measure the return of bonds against each other. In other words, it is the rate of return on a bond investment.

Yield, unlike the interest rate, is not fixed. Here"s why: when an investor buys a bond, they might hold it for a year or so and sell it when interest rates are higher. They will then get a lower price for the bond than they paid for it.

The buyer will receive the same interest rate that the investor did, and the same principal at maturity, but the yield they receive will be higher than that of the original investor because they pay less for the bond.

There are two main types of yield:

  • Yield to maturity

This tells you how much of a return you will get (in total) if you hold a bond until it reaches maturity. Therefore, it includes any capital you will gain if you purchase the bond below par or minus any capital you will lose if you purchase the bond above par, plus all of your interest.

  • Current yield

This is the annual return on the amount you paid for a bond, not taking into account its maturity.

What are the Risks?

As with any investment plan, it is wise to seek independent advice before committing capital to corporate bonds. While they may seem to offer a fairly low-risk way to invest, they are nevertheless open to risk of loss.

Furthermore, it is never recommended to place capital in a product or plan unless the investor understands it fully. All bonds (corporate and government) do carry a fair amount of "mechanics" and it is best to understand how they work before getting involved.

Carrying out research and training, talking to financial advisors, considering your own attitude to risk exposure these are all worthy actions before entering an investment.

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Investment Bonds

Investment bonds are not to be confused with corporate bonds or gilts (government bonds).

Investment bonds are a type of pooled investment and are intended to produce medium to long term growth yet may also be used to provide income. They are provided by life assurance companies, who take a lump sum from an individual investor this money will then be invested on behalf of the individual until they decide to cash it in. Some people have described investment bonds as loans made by investors to companies.

Investment bonds do not have a set length of time but are generally best to have for longer periods many will charge investors for cashing in the bond for the first 5 years.

Generally you can select from a variety of funds to invest in. For instance, you might choose shares (both UK and overseas), property, cash or fixed interest securities. You can, through an investment bond, invest in fund managed by other companies yet this can cost more in fees.

Investment bonds generally include an amount of life assurance and will pay out a bit more than the value of the bond on death.

How do you Pay for Investment Bonds?

When you open an investment bond, you can often choose how the company receives charges for managing your bond this involves allocation rates. This is the amount of money used to buy units within your funds and could be more or less than 100%. So, if the allocation rate is over 100% you could still be affected by other charges. If the allocation rate is 99% you are effectively paying a 1% charge on your investment.

  • Commission

You might be charged commission for advice received on your investment bond. Find out exactly what this commission covers.

  • Charges

There are charges involved including initial charges, cash-in charges (if you choose to cash in your bond in the first few years)

  • Tax

You will be required to pay tax on your investment bond. This is outlined in the next section but the amount you pay will depend on your circumstances.

Make sure which fees, charges and other costs are involved before you sign up. You will be subject to income tax.

Taxation Rules

Any returns made in investment bonds are subject to income tax. This will be paid automatically during the life of the bond.

The overall amount of tax you pay on investment bonds could be higher than on other investment types. However, there are still benefits to an investment bond as far as tax goes for instance, you might be able to provide a tax-deferred income. If you withdraw money from a bond, you can in most cases take up to 5% of the original investment on a yearly basis without immediate income tax liability.

Where can I Buy Investment Bonds?

You can buy bonds directly from a stockbroker, life assurance company or via a pooled investment.

What are the Risks?

By taking an investment bond, you risk that a company may not be able to repay its debt. A very famous case of this happening was in the United States, when fraudulent company Enron collapsed. However, companies are rated by rating agencies (the main ones being Standard & Poor"s, Moody"s and Fitch). Investors can use the rating information provided by these agencies to determine the level of risk that a company poses.

By opening an investment bond you are taking the risk that you might lose the money you invest. While you could make more returns than if your money was held in a savings account, you are placing it more risk. There are investment bonds which can provide a special guarantee that you won"t receive less than your original investment. However, in return they may charge a higher fee.


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