If you are wondering about investment you may well consider corporate bonds or gilts, but what are they and how do they work?
What are 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 (his 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.
What types of bonds are there?
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'.
Investing in bonds and gilts: how do they work?
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, whereas the risk attached to corporate bonds depends on the risk profile of the company that issues them. Issuers with a lower credit rating are considered more risky and 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 there being funds 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.
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 – it comes down to what risk the government is at in defaulting on payments – but the Treasury is likely to keep paying you
- Bonds are a good investment if you're looking for a predictable, stable income, although by investing directly, they do not offer significant capital growth opportunities.
- Corporate bond funds are protected up to £50,000 but only for mismanagement, not underperformance
- Premium bonds, fixed rate and inflation-linked bonds are covered up to £85,000 by the FSCS
- Single corporate bonds are not protected, so there's a larger element of risk involved
- Interest earned on bonds is usually taxed, unless the bonds are held in an ISA.
- With 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.
- 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 is not guaranteed.