Investing in Bonds
Bond investments go by a great many different names: loan stocks, debentures, preference shares and Gilts are all types of bond. Although they are all technically different they have some common characteristics.
A bond is a generic term for a debt instrument where interest payments to the holder are predetermined (either fixed or in line with a formula) as is the capital amount repayable on redemption. Bonds may be issued by companies, supranational organisations or governments. Bonds issued by the British Government are known as Gilt-Edged securities or Gilts to denote their relative safety. Bonds issued by companies may be secured on some or all of the assets of the company in which case they are known as secured loan stocks or debentures.
Because future cash flows from holding bonds to maturity are known in advance (or can be estimated) the return from them can be easily calculated. This is known as the redemption yield. Bonds that are perceived by investors to be risky (i.e. where the issuer may not be able to pay the interest as it becomes due or repay the full capital amount) offer higher redemption yields than those, such as Gilts, which are perceived to be low risk.
Most bonds offer fixed interest payments and redemption values but index-linked bonds offer interest and redemption values that rise in line with some measure of inflation such as the Retail Price Index. Floating rate notes (which are not strictly speaking fixed interest investments) offer a fixed repayment value but have interest payments that are variable depending on some reference interest rate such as LIBOR.
Because of the current relatively low level of interest rates in the UK many older bonds with high coupons (interest payments) are now selling at well above their repayment value. While the running yield (the coupon expressed as a percentage of the current price) on such stocks may appear attractive buyers must factor in the loss of capital value that will occur if they hold these stocks to redemption. This is why it is preferable to consider the redemption yield of a bond rather than its running yield.
Index linked bonds have both their coupons and their maturity value indexed to changes in an inflation index. In the UK this is normally the Retail Price Index (RPI) or Consumer Price Index (CPI). This means that index linked bonds are very useful instruments for those who wish to protect their capital from the ravages of inflation. The disadvantage is that these instruments offer a relatively low running yield.
Generally speaking bonds (except index-linked bonds) offer a higher redemption yield than the dividend yield on most equities and prices tend to be less volatile. These characteristics make conventional bonds attractive investments for those seeking relatively high income and low volatility from their investment portfolio. The disadvantage is that inflation can erode the buying power of the income and capital of conventional bonds over time. For this reason we generally recommend using bonds in conjunction with other asset classes such as equities when constructing portfolios. Where the preservation of capital and income against the ravages of inflation is vital it may be more appropriate to consider index-linked bonds.