UNDERSTANDING BONDS

The term bond has in the past been the generic term for fixed-interest stocks with security (the borrower is ‘bound’ to repay capital). Gilts are therefore bonds. However, in recent times the term ‘bond’ has also been used in the name of some equity-based investments, for example investment bonds issued by insurance companies; these are dealt with in the next chapter.

Local and foreign government bonds

It is possible to invest in these and they work like gilts. The only difference is that the risk of non-payment is greater, so the yield is higher.

Guaranteed income and growth bonds

These guarantee a relatively high return over a period, such as five years, with a full return of capital. They are more attractive during a period of falling interest rates, as the level of interest reflects the going rate at the time of purchase.

Income payments are made free of basic tax. They are not suitable for non-taxpayers as tax deducted cannot be recovered.

With income bonds the interest is paid out periodically whereas with growth bonds it is retained till the end of the investment period. Otherwise, they are identical.

High income bonds

Here a high fixed rate of interest is paid for a period, usually around five years.

The problem with them is that the capital value can be eroded. Usually there is a condition that, if a selected stock market index falls over the investment period by specified amounts, then the capital invested will be reduced by an appropriate percentage.

The lesson here is to read the small print.

Corporate bonds

These are company fixed-interest investments. They operate like gilts as the interest rate is fixed and so the market price varies. Interest is taxable but capital gains are tax free.

Debentures and loan stock

Debentures are company fixed-interest stocks which are secured on the company’s assets. The term loan stock is used to describe unsecured company fixed-interest stocks. Both have redemption dates when the loan will be paid back at a stated price.

Like gilts, the rate of interest is fixed and the market price will vary. Interest on loans is payable whether or not there are any profits and takes preference over dividends. Interest rates are usually quoted gross.

Also like gilts, capital gains are tax-free.

Preference shares

These are shares in a company rather than loans to it and usually do not have a redemption date. A fixed dividend is payable out of profits, usually before any dividend on ordinary shares (hence the preference). The market price will vary in accordance with the current rate of interest. Dividend rates are usually quoted net of tax.

Other corporate bonds

Zero-coupon bonds are sometimes available. Interest is not paid out but is ‘rolled up’ till redemption or sale and is then subject to capital gains rather than income tax.

’Bulldog’ bonds are those issued by foreign companies on the sterling market. They give higher yields because of the greater risk.

Eurosterling bonds are issued by companies in the EU (other than UK companies). They are usually bearer bonds, which means they are like currency notes so you need to keep them safe!

Corporate bond funds

Unit trusts and investment trusts are explained in detail in the next chapter, as they are mostly equity investments. However, there are also corporate bond funds which invest in a number of individual company bonds, thus spreading the risk.

High-yield corporate bond funds invest in more risky corporate bonds, which have a higher yield but more risk of capital loss.

PERMANENT INTEREST-BEARING SHARES

Permanent interest-building shares (PIBs) are another building society product. As the name implies, there is no redemption date. Interest rates are fixed (usually at higher rates than gilts) and therefore the market value moves with current interest rates.

PIBs can be a good investment for a fairly safe higher return when interest rates are expected to fall.

THE SAVINGS GATEWAY

This is a proposal to introduce, in 2003, incentives to encourage lower-income earners to save by offering to match savings with additional contributions paid by the government, probably on a tax-free basis.

This is still at the consultation stage, but it is expected that there will be a minimum period for saving, perhaps three years, as well as a maximum amount and an income threshold.

On maturity, the savings may be eligible for transfer to an ISA (See Chapter 7) or to the proposed Child Trust Fund (See Chapter 9 under investing for children).

CASE SCENARIOS

Amanda invests in National Savings

Amanda has some money on deposit for emergencies and intends to put most of her surplus cash into equities but in order to spread the risk she thinks about fixed interest for some.

In view of her higher-rate tax position, she goes for tax-free National Savings and decides on a five-year index-linked certificate.

Alistair and Jean think about gilts

Some of their inheritance should go into fixed-interest products, they decide. As they think interest rates will fall, they decide to invest in a gilt with a current interest rate below par, which they hope will give them a tax-free capital gain as well as an income.

They find one on the Bank of England Brokerage Service list and send off the application form they got from their post office.

Gwen and Hugh review interest rates

Before adding to their building society investment they check the interest rate against the competition. They could get more somewhere else and decide that changing now, before adding to their investment, would be worthwhile.

POINTS TO CONSIDER FURTHER

• 1.What are the relative advantages of tax-free National Savings certificates to the non-taxpayer, the standard-rate payer and the higher-rate payer?
• 2.Would you bother to change your building society deposit account for an extra 1% per annum? What factors do you take into account?
• 3.Corporate bonds pay higher interest than gilts. Why? Would you go for the higher rate in your circumstances?