Learn About Bonds
What are Corporate Bonds & Gilts?
Bonds (Gilts and other fixed interest securities) represent the debt of a government, company or other organisation. Effectively they are loan stock, or "IOUs" issued by these organisations and bought by investors such as banks, insurance companies and fund managers. Investors are often heard to say "I don't understand bonds", but the truth is that these instruments are much simpler than equities. The key factors can be broken down as follows:
- The Issuer: This is the entity that is borrowing the money.
- The Coupon: The issuer commits to pay a rate of interest per year. This coupon will generally be a fixed amount and paid annually or semi-annually.
- The Maturity: A date is set for the repayment of the money. This is known as the redemption date.
Types of Bond
Corporate bonds are issued by private and public companies and are considered more risky than government or supranational bonds because companies are much more susceptible than governments to economic problems, mismanagement and competition.
In general there are two main categories of corporate bonds: investment grade and speculative grade (also known as high-yield or even 'junk' bonds. Corporate bonds can be the most lucrative fixed-income investment, as you are generally rewarded for the extra risk you are taking. The lower the company’s credit quality, the higher the interest you're paid.
These are bonds issued by local governments such as borough councils. They are generally of a slightly lower credit rating than sovereign bonds, because they are not backed by central government and are not so easily traded in the secondary market.
UK government bonds are referred to as 'Gilt-Edged' bonds or 'Gilts'. They are widely regarded as the safest bond investments since they are backed by the UK government and therefore have the highest credit rating.
These are bonds issued by institutions such as the European Investment Bank (EIB) and the World Bank. As they are backed by a group of sovereign governments they are considered to be of high credit quality.
How risky are Bonds?
- The Issuer and the Guarantors could go out of business or become insolvent, you may lose some or, in the worst case scenario, all of your investment.
- Bonds are not covered by the Financial Services Compensation Scheme.
- Bond prices fluctuate from day to day according to the balance of supply and demand in the market. If you need to sell the asset before the Maturity date you could face a risk of capital loss.
- Many bonds are issued with embedded features such as "calls", which enable the issuer to repay the debt ahead of schedule and can be disadvantageous to the holder.
Popular Bond structures
Zero Coupon bonds do not pay periodic interest like normal bonds. Instead, zero-coupon bonds are sold at a deep discount. The investor's total return is represented by the bond's appreciation to start at maturity.
These are bonds in which both the coupon and the capital redemption are linked to the rate of inflation. Index-Linked bonds have a greater role to play in times of high inflation.
These are corporate bonds that give the holder the option to exchange the bond for a predetermined number of shares in the issuing company. They offer a slightly lower interest rate than corporate bonds because they can be changed into stock and so benefit from a rise in price of the underlying stock. If the stock performs poorly there is no conversion and the investor is left with a lower return than a non-convertible corporate bond would provide. This is the trade-off between risk and return.
These are a type of instrument issued by UK building societies. Technically they are not bonds, but a type of risk capital, being subordinated to deposits and other senior obligations of the society. Because of their fixed coupons PIBS behave in a manner similar to bonds. Individual issues vary greatly in coupon, price, yield and other features such as calls.
PIBS can be bought and sold on the LSE in round amounts, usually varying from 1,000 shares up to 50,000 shares. No stamp duty is payable on purchases. Unlike Gilts, PIBS cannot be redeemed, so in order to sell there has to be a buying counterparty in the market, therefore you may not be able to sell when you want to. PIBS are relatively illiquid, as the number/amount in issue is relatively small.
Like other fixed interest securities if interest rates rise then the value of a PIBS goes down; conversely, if interest rates fall then a PIBS value rises. There are also variable rate PIBS, where the interest rate changes in line with interest rates generally. Interest is payable annually or six-monthly in arrears. Rates are normally higher than the returns for Gilts.
Risks associated with PIBS
In the event of a Building Society becoming insolvent, all other investors would be paid first, and only if there was sufficient left would the PIBS holders be repaid. Theoretically PIBS are riskier than other Building Society investments and therefore generally attract a higher interest rate than ordinary Building Society cash accounts. Unlike other Building Society Investors, PIBS holders are not covered by The Financial Services Compensation Scheme.
Taxation associated with PIBS
PIBS are exempt from Capital Gains Tax but income is subject to Income Tax on interest. Income is paid gross with tax deducted through an individual's tax return. PIBS can be held in tax efficient accounts such as the TD ISA and TD SIPP.
Tax treatment depends on individual circumstances and may be subject to change in future.
The majority of bonds issued are "senior debt", meaning that the holder has a priority claim on the company's assets, ahead of that of the shareholders. Some bonds are issued with "subordinated" status. This means that the buyer of the bonds accepts a lower claim on the company's assets, below the senior debt holders, but above the equity holders. Because of the additional risk, a higher yield will be offered.
These are bonds where the coupon is not fixed, but based on a reference rate, typically LIBOR. They do not exhibit the same degree of interest rate sensitivity as conventional bonds. The majority of FRNs will be issued with maturities between two and ten years and will be senior debt. However, there is a class of perpetual floating rate notes which you may encounter from time to time. The majority of these are subordinated debt.
These instruments differ from convenentional Gilts as they have no set maturity date. They may (or may not) be paid back at a time of the government's choosing. Because of this the holder is reliant on the market price to liquidate the investment, and as such they should be viewed as more risky than conventional Gilts.