Gilts & Bonds

 

Bonds are IOUs. Gilts are government bonds – the main way the government borrows money. Investors who buy gilts are effectively loaning money to the government in exchange for a firm promise of repayment and a set rate of interest. Investors can also buy bonds issued by companies.

 

• What are bondsWhat are gilts bunds and treasuriesHow risky are giltsHow are bonds different from sharesHow can I invest in bondsHow do corporate bond funds workHow do I decide which bond fund to invest inHow do credit ratings affect bondsHow do interest rates affect bondsWhat other factors determine the price of a bondWhat other kind of bonds are thereconvertible bonds where the cost of raising money is cheaper than borrowing from the bank.Check out Moneyextra.coms Investment centre now.Top of PageGilts are specifically bonds issued by the UK government to finance its cash requirements. Gilt is short for gilt–edged stock originally the certificates themselves were actually gilt–edged. Most of them are sold with a fixed rate of interest for the life of the bond with a full repayment of the face value the nominal capital on maturity.Federal Reserve Board in the United States. The interest rates on Treasury securities have traditionally been used as the benchmark for interest rates throughout the US economy and international capital markets.Top of Pageyielding investments. There is a large variety of different stocks with different repayment dates allowing these types of institutions to match their future liabilities with gilts. Individuals too may use them for this purpose for example to fund a tax liability in a year or twos time or perhaps to plan for retirement on a known date.Top of Pagebuilding society deposits.Top of PageTop of PageTop of PageTop of PageTop of PageTop of PageTop of PageTop of Page

What are bonds

In general bonds are no more than IOUs. They are agreements under which a sum of money will be repaid to the bondholder after a set period of time. A bond is a loan made by you to a government or a company allowing them to raise money. In theory anybody can issue a bond but in general bonds are certificates issued by governments or public companies to repay money that they have borrowed.

 

National governments are not alone in finding that they have a shortfall between what they spend and what they can raise. Local authorities in trying to meet the rising social demands of residents – for education social services police etc. – are big users of the bond market. Many of the 100 biggest companies also raise considerable money from bonds particularly

 

You may hear people refer to a bonds coupon when they talk about the interest it pays. This dates back to past times when bondholders quite literally had to tear off coupons from their bond certificates and present them in return for payment of interest due.

 

Bonds issued by companies are usually distinguished as such by being described as corporate bonds. As corporate bonds are issued by a company and not a bank building society or the government you take the risk of the company staying profitably in business while you hold the bond. The bond pays out a fixed interest rate and usually has a life of 7 – 10 years. The bond may be sold or the interest taken until you redeem the bond for the original purchase price.

What are gilts bunds and treasuries

Government bonds are simply borrowings by governments which may be freely traded. The issuance of such bonds allows governments to tap both the domestic and international money markets to fund any shortfall between what they spend and what they raise in taxes. Government bonds are direct debt obligations issued by national governments. The governments use the revenue from bonds to raise capital andor refund outstanding debt.

 

Bunds are government securities issued by the German government and Treasuries is the term used to describe similar instruments issued by the

 

Gilts are issued in the first instance by the government in £100 units in minimum quantities of £1000 and for periods between 1–50 years. The gilt pays two fixed–interest percentage payments every year and promises to repay to you the face value – £100 per unit – at the end of the period. You cannot cash a gilt in before its official maturity date but you can sell it in the stock market. However the price will change from day–to–day and you should be aware that you may not be able to sell your gilt holding for the same price that you paid.

 

There are many different kinds of gilts. Some have only a few years to run short dates while others will pay interest for several years the long dates. Some are index–linked with their interest and capital payments adjusted for inflation. Others are strippable – this means that the individual interest and redemption payments may be bought and sold separately in the market. Gilts may be bought and sold in the stock market in any amounts.

How risky are gilts

Since government bonds are backed by the full faith and credit of the issuing government they are generally considered to be a better credit risk than corporate bonds. However this is only the case of certain government bonds; treasuries and gilts for example which are viewed as virtually free of credit risk. The same view may not be taken of bonds issued by governments in South America and Africa.

 

Because of the relative lack of credit risk here in the UK gilts are used mainly by insurance companies pension funds charities and trusts all of whom generally want safe high

 

There is little or no risk in holding gilt–edged stocks as long as they are bought at a price that is at or below their repayment face value of £100. The twice–yearly interest payments are guaranteed by the UK government and the repayment value is similarly guaranteed. Thus if you bought £100 Treasury 4.75 2010 at a price of £97.31 price at 040607 in the stock market you are certain to receive £4.75 every year and you are also certain to receive repayment on your investment at a price £2.69 greater than your purchase price if held to redemption.

 

Every traditional gilt–edged stock pays out interest twice a year. The amount they pay can be calculated by multiplying the face value of the holding by the coupon rate of interest shown in the title of the gilt. Thus £100 of Treasury 4.75 2010 will always pay two interest payments during the year of £2.375.

How are bonds different from shares

Shares are a way of owning part of a company. As part–owners of a company shareholders may share in the companys profits through dividend payments but will also see the value of their investment fluctuate as share prices rise and fall. The return on investment in shares through the dividend income stream will depend on the quality of the companys earnings and may fluctuate from year to year.

 

The share price is itself vulnerable to a variety of factors of which the companys own actual performance may be the least important. Anything from the general health of the economy to the amount of shares changing hands the liquidity of the market can drive a share price sharply up or sharply down.

 

Corporate bonds do not confer ownership. The price of bonds and gilts may be affected by changes in interest rates and inflation rather than by fluctuations in the stock market although both are traded on the stock market where their price can go up or down.

 

Bonds tend to be less volatile than shares and ordinarily pay a steady stream of income as the rate of return is "fixed" not "variable" as it is for ordinary shares bank and

 

Bonds whether issued by the government or companies tend to have a fixed lifespan. At the end of the period is the redemption date also known as maturity. This is when the face value or par value of the bond will be repaid to the bondholder.

 

Although the price of bonds is set at issue and maturity it will fluctuate over the intervening period. During the bonds lifespan the bond issuer will usually make a regular interest payment or coupon payment. The size of this payment is usually fixed at issue and will not vary although some bonds may be index–linked to take account of the effect of inflation.

 

The income you receive from bonds is called the yield. The distribution yield may be worked out by dividing the coupon by the price you paid for the bond.

 

Bonds also have what is known as a redemption yield which works on the same principle as the distribution yield but which also takes into account the prospect of any capital gain or loss that you might make by holding the bond to maturity. So you work out redemption yield by adding in the potential capital gainloss to the coupon payments.

How can I invest in bonds

Bonds are among the most tax–efficient investments you may make within an Individual Savings Account ISA. Under current tax rules you benefit from a tax reclaim of 20 on interest distributions.

 

Within an ISA you may invest in gilts similar securities issued by governments of other countries in the European Economic Area and strips of all these securities with the stocks and shares component of an Individual Savings Account. Your ISA may also include corporate bonds issued by companies listed on a recognised stock exchange anywhere in the world or corporate bond funds including such bonds.

 

Bonds are generally considered less risky than shares but as a general rule the higher the apparent rate of return the higher the risk. You may buy and sell bonds on the market throughout their lifespan. You do not have to hold bonds to their redemption date.

 

If you are looking for income that may be higher than you can achieve through an ordinary deposit account bonds may be a means of achieving that goal. Bonds offer a lower–risk investment than shares and allow you to plan for upcoming expenditure or create a steady income stream. However they may not be suitable for some investors and you should seek independent financial advice before investing.

 

The amount of your portfolio devoted to bonds will depend on how much risk you are willing to take your investing goals and current needs together with the prevailing economic conditions. At different times you will want to move more money into the bonds market particularly when approaching times in life where you cannot afford to be in high–risk investments.

 

In broad terms a rough rule of thumb that you may wish to consider is that which suggests that the percentage of bonds in your investment portfolio should reflect your age. Thus at age 30 you would be 30 invested in bonds but at age 65 65 of your portfolio should be in bonds. This is only a very rough and ready suggestion and you need to consider your own attitude to risk and your financial requirements. You may find it useful to take independent financial advice to assist your decision–making process.

How do corporate bond funds work

When you invest in a bond fund also described as a fixed interest fund your money is pooled with that of other investors and is then invested in a range of bonds by the fund manager. In theory this reduces your investment risk since you are not relying on a single company or government to honour the interest payments coupon and redemption payment return of capital at maturity.

 

You also benefit from the expertise of the fund management group and the research it has carried out on the quality of the bonds it buys.

 

Some corporate bond funds may offer high rates of income but do so through taking correspondingly bigger risks. Two agencies Moodys and Standard &Poors specialise in grading the quality of corporate bonds. They award ratings based on ability to pay interest and the likelihood of the capital debt being repaid on maturity. The best rating is Aaa or AAA. The lower a bonds credit rating the higher the risk and the more return you can expect.

How do I decide which bond fund to invest in

You need to be sure that you understand the answers to some basic questions. You need to know what type of bonds the fund invests in how the fund manager generates income how the fund manages risk and finally how much attention the fund manager pays to research.

 

So your starting point is the type of bonds and the range of credit ratings in which the fund invests. You should also know whether the fund is taking more risks by investing in junk bonds more politely known as sub–investment grade bonds and whether it is exposed to shares holding convertibles preference shares or even having direct equity stakes in companies.

 

A bond funds income is generated by the average interest or coupon on the bonds held in the funds portfolio divided by the price of the bonds. Be aware that fund managers can make fund income look more impressive than it might otherwise appear but only do so by effectively eroding capital. You should also watch out for funds that inflate income at the expense of capital depending on whether a fund charges its expenses to capital or income.

 

The main risk factors for bonds are interest rate risk and credit risk which we explain in more detail further on. You need to be able to understand the risk profile of the bond fund; is it for example more sensitive to interest rates changing or are the bonds invested in companies or indeed countries that may have difficulty paying interest or redeeming them. Consider also whether the fund is spreading its risk across a range of assets in terms of industry sectors geographical spread etc. The more a fund is focussed on just one sector the higher your risk is likely to be.

 

Finally what criteria does the fund manager use to choose the bonds in which the fund invests Does the fund management group have a research capability The specialist credit rating agencies play a useful role but do not always cover all risks. For example event risk such as being taken over or being involved in a take over that may stretch a companys finances.

How do credit ratings affect bonds

A corporate bond is just a loan to a company. The bigger the company the lower the rate of interest they will pay because they are deemed to be low–risk. Smaller businesses pay more interest effectively as a risk premium. Remember the higher the returns on a particular bond or bond fund the poorer the "investment quality" of its holdings. Watch for the "rating" of the bonds.

 

Here are the different ratings or investment grades

 

 

		Standard & Poors		Moodys
Best Quality		AAA		Aaa
High Quality		AA		Aa
Upper Middle grade		A		A
Medium Grade		BBB		Baa

Moneyextra.com recommends you take independent financial advice before acting on any article

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2009-02-17 00:00:00 © Moneyextra.com