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FOOL SCHOOL
Bonds And Gilts - Part I

October 10, 2005

Bonds are one of the four main asset classes, the others being cash, shares and property. At its simplest, a bond is just a loan. If a government, company or financial institution wants to borrow some money, one of its options is to issue a bond. Typically, they'll pay interest (or a coupon) on a regular basis and then repay (or redeem) the full amount of the loan (the principal or nominal value) on a pre-determined date (the maturity date).

Bonds, which are also known as fixed-income investments, are riskier than cash but less risky than property or shares. Consequently, over the long term, you'd expect bonds to return more than cash but less than property or shares.

Investors can buy and sell bonds, through a broker, just like shares. The price of the bond depends on many factors. However, the most important factors are the outlook for interest rates, how long until the bond is redeemed and how financially secure the issuer of the bond is.

Before we get into the meaty stuff, it's worth noting that the term 'bond' is widely abused by the financial services industry. You may have heard of terms like 'savings bond', 'investment bond' and 'guaranteed equity bond'. In most cases, these aren't bonds at all but the term is used to give these products an air of solidity and security that many of them do not deserve.

Main types of bonds

Gilts

Gilts are bonds issued by the UK government. Most governments issue their own bonds. In the US, they are called Treasury bonds or T-bills. German government bonds are known as bunds.

Most gilts pay a fixed rate of interest every six months but you can also get index-linked gilts where the interest paid and the final redemption amount rise in line with the rate of inflation. Gilts that are due to be redeemed within 7 years are known as 'shorts'. Those redeemed between 7 and 15 years hence are known as 'mediums' while those over 15 years are known as, believe it or not, 'longs'. Then there are some gilts which are undated, meaning that they have no redemption date.

Gilts are usually sold in blocks of £100 nominal value. You will therefore see prices for them quoted in newspapers and on web sites at around this price. You'll see them listed as, for example, 8% Treasury 2013. The 8% is the rate of interest paid on each block of £100. Because rates are lower than this at moment, it will cost you more than £100 to buy this gilt today. 2013 is the redemption date. The word in the middle, such as 'Treasury' or 'Exchequer', is apparently to help differentiate one gilt from another.

At the moment, the gilts market is worth in the region of £300b. So it is significantly smaller than the UK stock market, which is currently worth around £1,300b. There is a lot more information on gilts on the DMO web site, including a rather useful private investor's guide.

Corporate Bonds

Corporate bonds are bonds issued by a company. They can be split into two main classes. Bonds issued by large, reputable companies, such as GlaxoSmithKline and BAA, are referred to as investment grade bonds. Those issued by companies with less secure finances are known as non-investment grade, high yield or junk bonds.

High yield bonds, as the name implies, offer a higher rate of interest than investment grade bonds. But there is a significant risk that the company may not be able to pay (or default) on the ongoing interest payments or redemption payment. As a group, high yield bonds tend to behave more like shares than gilt and investment grade bonds.

Some companies issue convertible bonds. These are bonds that can be converted into shares at a later date. As they offer extra upside if the share price does well in the future, convertible bonds usually pay a lower rate of interest than non-convertible bonds.

The UK corporate bond market is slightly smaller than the gilts market, currently being worth about £200b. Bondscape is a useful site if you want to track the prices of individual corporate bonds.

PIBS

Some building societies have issued bonds, known as permanent interest-bearing shares (PIBS). Unlike most bonds, PIBS have no fixed redemption date. Those bonds issued by building societies that subsequently floated on the stock market are referred to as perpetual subordinated bonds (PSBs). If a building society were to go under, PIBS investors would only get their money after ordinary savings account holders got theirs.

PIBS can be difficult to buy and sell as there is only a small market for many of those issued. In addition, you have to invest a minimum amount. This is usually £1,000 for the smaller building societies but can be up to £50,000.

Online resources for PIBS are rather thin on the ground but you can usually find details of their yields and minimum investment amounts in the weekend money sections of most papers. The market for PIBS is very small, currently being worth less than £1b.

Tax and bonds

The interest on gilts, corporate bonds and PIBs is subject to income tax although it is usually paid out without any income tax being deducted, unlike other income investments like a savings account for example. You can put gilts, corporate bonds and PIBS into an ISA and thereby avoid paying any income tax on them.

Any capital gains you make are free from tax. Say you buy a gilt with a price of £80 and a redemption value of £100. If you hold the gilt until redemption, the gain of £20 would be tax-free. Fantastic! Unfortunately, you don't get any relief for capital losses. So if you bought a gilt for £120 that had a redemption value of £100 you would not be able to offset the loss of £20 against any other gains you made. At the moment, most gilts are priced above their redemption price, as they were issued when interest rates were much higher.

Unlike shares, you don't have to pay any stamp duty when you buy gilts, corporate bonds or PIBS.

In the next part, we'll look at how bonds are valued and introduce the exciting topic of yield curves!

> Part II | Part III