What are bonds and gilts and how do they work?
What are bonds and gilts and how do they work?
What is a fixed income investment?
A fixed income investment is a type of financial product that generates a set level of cash flow over a set period of time. This is often in the form or a bond, gilt or annuity. Typically, the level of money generated is known at the point of purchase alongside the frequency that payments will be made. In some cases, the capital cost of the investment is returned at the end of the period and in others (as is the case with annuities) the income will continue for the life of the investor, however the capital is retained by the institution when the investor dies (unless protection is added at the point of purchase).
Depending on their financial circumstances, investors may want to consider a range of fixed-income investments as part of their portfolio for a number of reasons, including:
A guaranteed income that is not subject to the dramatic ebbs and flows of the stock market.
The ability to select the rate of return, depending on the level of risk they are willing to accept.
A place to park excess cash for the long term, other than in a savings account, although the capital is still at risk and the value may be affected if the investment is sold before maturity or the bond issuer falls into financial difficulties.
This article focuses on bonds and gilts, whereas annuities are covered in a separate article.
What are bonds?
Bonds are a type of fixed-income investment that is essentially a loan between one party and another. Typically, bonds are issued by companies and governments as a means of raising capital or refinancing existing loans. Companies may be looking to fund expansion or new research, whereas governments may be borrowing to fund infrastructure projects such as roads, ports or dams; often though it can be used as a means of raising the funds for war.
An easy way to put bonds into context is to think of a large company that is looking for a loan to build a new data centre. So, rather than going to a high street bank that may not wish to accept all the risk as a single party, the company decides to issue corporate bonds to investors that have a suitably attractive interest rate for the level of risk the loan represents. In this situation, the bonds issued by a FTSE100 company are likely to offer a lower rate of return than a bond issued by a less established organisation.
Interestingly, even though bonds fall into the ‘fixed-income’ category, it is actually possible to have variable interest rates for the repayments. Furthermore, there is an inverse relationship between bonds and interest rates; typically, when interest rates rise, the value of bonds may fall and when interest rates fall, the value of bonds may rise, although these price fluctuations only affect those buying or selling bonds ‘mind-term’ and before maturity.
What are gilts?
A gilt is the name for a bond issued by the governments of the United Kingdom, fellow Commonwealth countries and India. Gilts are the equivalent of US Government Treasury securities. The term Gilt originated from the golden gilt-edged certificates that were originally printed but today, the word gilt is also used to describe any bond that has both a low risk of default and a low rate of return. The value of gilts can fluctuate depending on how the world feels about the UK government at the time and major economic shocks or movements in the British economy may cause the value of gilts to fall.
How do gilts and bonds work?
When a bond is issued, all the details of what the repayments will be, what the interest will be and what the repayment date for all the capital to be returned is agreed. For bonds, the regular payments are referred to as the ‘coupon’.
The original issue price is known as ‘par value’ and, if the bond or gilt is sold before maturity on the secondary bond market, the market price will be affected by the credit worthiness of the issuer, the coupon payment rate when compared against interest rates in general and how long the bond has left to return before maturity. The amount that will be paid back once the bond matures is known as the ‘face value’.
Bond issuers may seek to buy back bonds if interest rates fall to take advantage of lower interest rates as they can then issue new bonds with a reduced coupon, saving them money over the longer term.
Can you lose money on bonds?
Yes, you can lose money on bonds. Bonds have an inverse relationship to interest rates therefore if interest rates rise, the value of existing bonds on the secondary bond market will fall because they are less attractive to investors in the marketplace who could purchase bonds with a higher coupon and yield. Furthermore, the company that issued a corporate bond could default on the repayments and even go out of business, so clearly your capital is still very much at risk.
Can you lose money on gilts?
Yes, you can lose money on gilts. Gilts have an inverse relationship to interest rates therefore if interest rates rise, the value of existing gilts on the secondary market will fall because they are less attractive to investors in the marketplace who could purchase gilts with a higher coupon and yield. Furthermore, the value of a gilt could be affected by the performance of the UK as a whole and what the market sentiment is regarding its economic outlook. However, given the overall stability of the UK, it is looked upon as one of the lower-risk government bonds available as there is a comparatively low risk of the UK government defaulting. However, your capital is still at risk.
Are bonds and gilts a good investment?
Bonds and gilts are typically seen as a way to balance your investment portfolio against the comparative volatility of the stock market, therefore reducing your overall risk of loss overall. For this reason, many multi-asset funds will split the holdings in a fund between bonds/gilts and equities (shares).
To illustrate this point, one of the largest multi-asset fund managers is Vanguard. One of their main managed fund types is called ‘LifeStrategy’ and investors can choose from:
80% bonds and 20% shares, with a risk rating of 3/7.
60% bonds and 40% shares, with a risk rating of 4/7.
40% bonds and 60% shares, with a risk rating of 4/7.
20% bonds and 80% shares, with a risk rating of 5/7.
0% bonds and 100% shares, with a risk rating of 5/7.
As you can see, the more the portfolio is weighted towards shares, the greater the risk rating and vice versa. The Vanguard website is also able to illustrate how the returns have fared over the past few years as follows:
Vanguard life strategy performance by year July 2017 to July 2022.
These Vanguard funds are just an example of how investments of this type can perform. There are hundreds if not thousands of funds like this available to investors and which one is the most suitable will depend on a variety of factors. Seeking independent financial advice can help investors wade through the myriad options that exist to find the most suitable for them in meeting their financial objectives.
Conclusion.
In light of everything so far, in theory, one may assume that a lower exposure to the stock market and a greater exposure to bonds and gilts may offer a reduced risk of loss. However, it’s clear from the Vanguard table above that, in times of rising interest rates, a portfolio that is too heavily weighted towards bonds may actually offer the greatest potential for loss.
Nonetheless, all investors have different attitudes toward risk and different aims for their investment portfolio. As a result, it’s crucial that you work with your financial adviser to discuss the different asset types available to you and how your portfolio can be balanced to meet your goals.
What’s next?
If you need help or advice on your personal or business finances or if you want to consider investing to make your money work harder, you can get in touch with one of our advisors for independent financial advice. We offer a free initial consultation and although we are based in Tunbridge Wells, we advise clients across the UK.
Don’t forget, this article offers information about investing and should not be taken as personal advice. Remember that investments and pensions can go up and down in value, so you could get back less than you put in. Tax rules can change and the benefits depend on individual circumstances.