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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 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 convertible bonds where the cost of raising money is cheaper than borrowing from the bank.

You may hear people refer to a bond's 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.

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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 and/or refund outstanding debt.

Gilts 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.

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

Gilts are issued in the first instance by the government in £100 units in minimum quantities of £1,000 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.

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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 yielding 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 two's time or perhaps to plan for retirement on a known date.

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 04/06/07) 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.

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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 company's 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 company's earnings and may fluctuate from year to year.

The share price is itself vulnerable to a variety of factors, of which the company's 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 building society deposits.

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 bond's 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 gain/loss to the coupon payments.

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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.

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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, Moody's and Standard & Poor's, 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 bond's credit rating, the higher the risk and the more return you can expect.

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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 fund's income is generated by the average interest or coupon on the bonds held in the fund's 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 company's finances.

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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 & Poor's Moody's
Best Quality AAA Aaa
High Quality AA Aa
Upper Middle grade A A
Medium Grade BBB Baa

As an individual investor you should probably not invest in bonds or in a bond fund which holds bonds rated less than Baa or BBB. You will hear such bonds described as junk. What does it actually mean? According to Moody's, bonds which have a B rating generally lack characteristics of a desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small.

In plain English, your chances of getting both the interest payments on a regular basis and the return of your principal when the bond matures may not be that great. Junk bonds pay a much higher rate of interest than investment grade bonds as a risk premium. This is generally not a market for private investors.

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How do interest rates affect bonds?

When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. You will also hear bonds called 'fixed-interest securities'. This is because the borrower usually pays a fixed amount of interest. But the price of existing bonds can change in the stock market to reflect changes in the economy.

Let's say a bond has been issued with a face value of £100 and fixed rate of return of 5%. If the bond's market price then falls to £80, the fixed rate of return is still £5 (5% of the face value) but the yield against the market price has risen to 6.25% (£5 as a percentage of £80). So, if the base rate rises, the market price of the bond will fall in order to bring the current yield into line with general interest rates.

Likewise, if general interest rates fell then the market price of the bond would rise, say to £125, reducing the yield to 4% (£5 as a percentage of £125). To find out how much you'll make from the bond, or the bond's 'income yield', divide the fixed interest rate by the price you paid for it.

Obviously, if you buy a bond above its issue price or par value, you'll suffer a capital loss if the bond is held until redemption. But if you buy a bond below its issue price, you'll make a capital gain. In theory these capital gains and losses should be offset by losses or gains based on the changing yield of the bond's interest or coupon payments.

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What other factors determine the price of a bond?

Interest rate movements are the key determinant in the price of bonds. However, there are other issues that you need to take account of as well. Corporate bond price performance will also be affected by the general health of the issuing company. Movements in the bond price are likely to be less volatile than movements in the company share price, given that the bond return is fixed while dividends are not.

Similarly, government bond prices in the stock market will be affected not just by changes in interest rates but by how the government and its policies are perceived by the market at large. A rising government deficit, which indicates the government is spending more than it takes in through taxation, suggests that the government will issue more bonds. The laws of supply and demand tell us that such action will drive bond prices down.

If a company or government credit rating grade is altered by the ratings agencies this can have a dramatic effect on bond prices. A downgrade, indicating that the issuing entity is less likely than before to repay its loans, will cause the price of the bonds to fall and the yield to rise (thus rewarding new investors for the additional risk they take).

The general health of the economy is also a factor, so also is the external value of the currency and the risk of inflation, which would eat away at your initial capital investment in bonds. The broader performance of the stock market will also have an effect. Falling share prices tends to lead investors to switch funds out of equities and into bonds, which are seen as more stable, thus boosting bond prices.

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What other kind of bonds are there?

There are a lot of potential investment vehicles that include the word bond in their name or title. Government bonds and corporate bonds are but two of them. You must make sure you understand what kind of bond you are investing in before you decide to commit your funds.

Be aware of the difference between bonds that pay a fixed interest and those that do not. Some bonds or bond funds may have a substantial shares element, relying on the performance of the stock market to meet their specified rate of return. Bonds exposed to shares include high-income bonds, with-profits bonds and guaranteed equity bonds.

You must be able to distinguish which kinds of bonds may put your capital investment at risk. Among bonds in which your capital may not be returned in full are: high-income bonds dependent on stock market index growth; with-profits bonds; corporate bonds and gilts.

Premium Bonds

Perhaps the 'bond' that we are all most familiar with: the National Savings Premium Bond was introduced in 1956 by Harold Macmillan as 'something new for the saver of Great Britain', Premium Bonds are effectively government bonds. However, as an individual you forego interest and instead your bond numbers are entered into a monthly draw for prizes ranging from £50 to £1million. The interest paid on premium bonds (3.80% as of 01/07/07) is pooled together to create the prize fund. Each month there are two £1 million jackpots plus, at the current odds, over a million other tax-free prizes ranging in value down to £50, all free of UK Income Tax and Capital Gains Tax.

High-Income Bonds

You will be required to tie-up your money for a fixed period, typically of three to five years. High-income bonds guarantee to provide you with an income, which may vary from 7-10% or more. However, in order to achieve this income, your capital is at risk and you could, at the end of the term, receive back less than you invested. Each plan is linked to a particular stock market index, and will return your original investment in full only if that index hits certain targets. There is, therefore, a risk that you could lose most or all of your money if the target is not achieved.

With-Profits Bonds

The idea of a with-profits bond is to smooth out the fluctuations in the stock market, providing a low risk, low volatility investment. Designed for the medium to long term, you must be prepared to invest your capital for at least five years. The return on your investment may vary from year to year. You may take an annual income from the investment for 20 years or until the bond is encashed. Any income up to 5% of your original investment is seen as a return of your capital by the taxman so any tax liability is deferred. As with other with-profits products you will be heavily penalised if you end the policy early or make lump sum withdrawals. Your capital investment is at risk if the income you take is greater than the return produced by the bond's with-profits bonuses. A with-profits bond is not intended as a short-term investment. Exit charges may apply. If you encash the bond in its early years you may not get back all of your original investment. Bond providers have the right to apply a Market Value Adjuster (MVA) that may act to reduce the value of your investment upon encashment or transfer. The MVA is applied at times when investment conditions make it necessary in order to protect the interests of policyholders remaining in the fund.

Unit-Linked Bonds

The performance of unit-linked bonds directly reflects how well or badly the underlying assets are performing. This makes them more volatile than with-profits bonds and the value of your investment cannot be guaranteed. It is easy to keep a check on your bond by simply multiplying the number of units you hold by the prevailing selling price on any particular day. These bonds are generally intended as long-term investments although you may take an income from them. However, if the amount you take is more than the income being generated you could erode your capital. Instead of receiving an income you can have the income reinvested to enhance capital growth.

Guaranteed Income Bonds

Your capital is not at risk in a guaranteed income bond. These are straightforward savings plans that offer fixed returns if you invest for a fixed period, not unlike a long notice account from a bank or building society. Life companies issue them. The return you are offered will vary depending not only on the firm but also the sum you invest and the length of time for which you are prepared to commit it.

PIBS: permanent interest bearing shares

Although technically shares, PIBS are actually bonds issued by building societies. They have no redemption date, hence 'permanent' and are bought and sold via the stock market. The basic minimum investment in PIBS is £1,000 but individual issues may have a much higher minimum. Even if a building society demutualises, its PIBS do not disappear. Instead they become PSBs (perpetual subordinated bonds). PIBS and PSBs carry fixed rates, though these can vary sharply between issuers and the actual return, the yield, will be affected by the price you pay in the stock market.

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13 August 2007 © Moneyextra.com