Corporate bonds and gilts can be a good investment choice if you're looking for investment that grows, or pays out an income. But what is a corporate bond and what is a gilt, and how do they work?
What are bonds?
A bond is like an IOU. It's issued by a bank, government or company and pays a fixed interest to the person who holds it. You can have a savings bond, also known as a fixed interest savings account, which runs for a set amount of time. You can buy government bonds, which are fixed interest products issued by the government. Or you can buy company bonds, known as corporate bonds, which are issued by companies.
How does a bond work?
Put simply, a bond is when you lend money to an organisation and you receive a fixed amount of interest in return. Some bonds are more risky than others. Bonds issued by the UK government, known as gilts, are considered to be the most secure type of investment alongside savings accounts from regulated banks and building societies.
Bonds are a way for companies or governments to raise money without issuing shares. You can buy a bond from a company, or from the government, which has issued a bond. In return, the bond issuer pays you a regular sum of money, known as interest. At the end of the fixed term, you cash in your bond and get your money back.
Is a bond a good investment?
Different bonds carry different levels of risk, and when you're looking for the best corporate bond or gilt you need to think about how much risk you are willing to take with your money.
Bond prices rise and fall depending on a number of different factors, but the interest rate they pay you says the same once you have bought the bond.
The price of a bond rises and falls depending on how risky it is thought to be, how likely the investor is to get their money back, and how attractive it is compared to other investments at the time, such as shares. You can buy a bond when it's first issued, or you can trade pre-owned bonds in the stockmarket.
What are corporate bonds?
Bonds issued by companies are known as company or corporate bonds. A bond is a form of debt issued by companies (corporate bonds) or the government (gilts) to raise money. In other words, they are loan stock, or "IOUs" and used as investment options.
If you buy a bond you are, in effect, lending money to the issuer. In return, the issuer promises to pay you a set rate of interest each year (this payment is known as a coupon) and to repay your capital at a set date in the future, known as the redemption date.
Depending on how far in the future this date is set, corporate bonds and gilts can be short term investments, medium term investments, or long term investments.
What are gilts?
Gilts are a form of bond or IOU issued by governments wanting to raise money, and they are known as gilts.
Corporate bonds are issued by corporations and gilts are bonds issued specifically by the British government.
There are different types of gilts, but the majority are conventional gilts. These normally pay a fixed coupon twice a year and mature on a set, fixed date in the future. You can also buy index-linked gilts, where both the coupon payment and the value of the bond change according to the Retail Price Index (RPI) - a measure of the rate of inflation - or you can buy undated gilts, where there is no fixed redemption date.
Gilts typically pay coupons twice a year, whereas corporate bonds are more likely to pay coupons annually. They both offer a source of fixed income and investment options; the opportunity for capital growth is modest.
There are also investment bonds, which are not actually the same as a bond. Rather a fund that allows you to make a return on a single unit or with-profits fund and withdraw up to 5% from your original investment each year. These types of bonds are often seen as an 'income producing investment'.
Is it a good idea to invest in bonds and gilts?
Bonds are usually issued at £100 each and pay back £100 when they are redeemed, plus interest at a fixed rate each year until then. You can buy on the second hand market, although the price you pay will be governed by the rule of supply and demand and prevailing interest rates. If you buy for more than £100 and hold the bond until maturity, you will get back less than you invested.
If you pay less than the issue price you will make a gain when the bond matures. However, the market price is linked to interest rates - a lower price reflects a lower rate of interest, so when buying a bond or gilt you should consider the overall return that it offers you.
Investing in bonds and gilts: how risky are they?
In general, bonds are lower risk than property or equities, but higher risk than investing cash in a savings account. Gilts are considered virtually risk-free as they are as good as guaranteed because they are backed by the government.
The risk attached to corporate bonds depends on the risk profile of the company that issues them. Issuers with a lower credit rating (ie the underlying company is thought to be less secure) are considered more risky. They will typically offer a higher rate of interest to attract investors, and to compensate bond holders for the additional risk.
If a company collapses, bond holders will be paid before shareholders, but ultimately repayment will depend on funds being available. For this reason, the return from bonds is not guaranteed. It's therefore important to select an issuer who matches your risk profile. Find out more about investment risk.
Are some bonds risky?
Different companies issue bonds with different levels of risk. When you're looking at the best bond rates and bond yields, or comparing bond fund options, you need to bear in mind that the higher the rate of interest, the higher the potential risk.
Riskier bonds are known as high interest bonds or junk bonds because the underlying company carries more risk. If you're looking for a more secure type of bonds to buy, you could consider investment grade bonds instead which are considered to be less risky.
If you want to check the price of gilts or gilt yields, you can look at the UK gilt prices chart, which should what the current interest rates are, including the 10 year government gilt yield.
What are bond funds?
You can invest in a spread of government and corporate bonds through a bond fund. This effectively lowers your risk because if one bond fails to meet its payments you only have a small proportion of your fund invested in it, rather than possibly all of your money.
However, because of the mix of maturity dates and interest rates, bond funds cannot guarantee a fixed return, they can only give an estimate of the amount of income payable over the next 12 months.
Investing in corporate bonds and gilts: a summary
- In general, bonds are lower risk than property or equities, but higher risk than investing in cash. Gilts are less risky than corporate bonds.
- Gilts are not protected by the government compensation scheme, but they are regarded as a safe investment because they are backed by the UK government.
- Bonds could be a good investment if you're looking for a predictable, stable income, but they don't offer significant capital growth opportunities.
- Premium bonds, fixed rate and inflation-linked bonds are covered up to £85,000 per eligible person, per bank, building society or credit union by the Financial Services Compensation Scheme (FSCS), which covers up to £170,000 for joint accounts.
- If you make an investment, and the firm failed after April 1 2019, then you may be eligible for compensation from the FSCS up to £85,000, but this doesn't cover a direct investment in a corporate bond where the company goes bust.
- Single corporate bonds aren't protected, so there is a larger element of risk involved as if the underlying company doesn't pay your capital back you can't claim compensation.
- Interest earned on bonds is usually taxed, unless the bonds are held in an Individual Savings Account (ISA). However, each adult has a Personal Savings Allowance (PSA) of £1,000 a year if they are a basic rate taxpayer and £500 a year if they're a higher rate taxpayer. You don't have to pay tax on income, dividends and other investment income up to this threshold, and this includes income from corporate bonds and gilts.
- With saving in fixed rate bonds you have easy access to your money, unlike an investment in property for instance.
- You can normally sell bonds at any time with minimal impact to the capital invested, for this reason they can be a suitable choice for short to medium-term investment.
- Modest capital gains are possible, these are tax-free on gilts and on some corporate bonds and investment bonds.
- A bond fund allows you to purchase a mix of bonds and gilts lowering the risk of the investment, but the income you receive will vary and isn't guaranteed. You can buy bond funds online and you can buy corporate bonds and UK government gilts online as well.