Investing Basics: Bonds and fixed interest

An at-a-glance guide to fixed interest investments; one of the more jargon heavy areas of investment – by Tabitha James

What is a bond?

 
A bond is form of investment which usually offers little potential for capital growth, but pays a ‘coupon’ which simply means regular income, to the investor while he or she holds it.

They can be issued by a corporation to raise money, or by a government for the same reason. The amount of income that bonds pay tends to reflect the ‘risk premium‘ attached to them. What this means is that the riskier a company (or country) is, the higher the ‘coupon’ its bonds will offer.

Naturally, very large and well established companies with solid earnings and high ‘ratings’ from ratings agencies like Standard & Poor’s tend to pay a lower coupon – because the risk premium attached to owning their bonds is lower.

Government bonds, also known as ‘sovereign bonds’ or ‘gilts’ (the latter usually only refers to those issued by the Bank of England), tend to pay lower coupons still – the theory being that countries are even less likely to collapse than corporations.

Maturity

 
Bonds are sometimes referred to as ‘debt’. This is because, effectively, they are a means for a company or country to borrow money from investors.

The coupon in this light can be seen as an interest rate paid to the investor (the creditor). For the same reason bonds have a ‘maturity’ date because they have a fixed lifespan.

This lifespan is rarely less than one year, and can – particularly for government debt – be very long indeed. UK Gilts, for example, come in three main maturity dates – 0-7 years, 7-15 years and 15 years or more. Some UK gilts have maturities in excess of 50 years.
 

What is fixed interest?

 
Fixed interest is simply another term for bonds. It relates to the fixed rate of ‘interest’ or income that bonds or gilts pay in the form of their coupon.
 

Investment grade vs sub-investment grade bonds

 
Investment grade bonds are those issued by companies which are considered by ratings agencies like Standard & Poor’s to be less likely to default (go bust), so anything below that level (investment grade bonds are rated BBB or above) is higher risk in terms of this definition.

As a result, the ‘coupon’ or ‘yield’ these sub-investment grade bonds pay is higher – reflecting the risk premium attached to them – and they can generate a higher income if the manager is able to avoid the ones issued by companies which go bust.

Generally, the higher the yield on offer, the riskier the bond paying that yield is considered to be.

Yield can also be affected by the amount of time left before a bond matures and the price of the bond at any given time. If the price of a bond drops, for whatever reason, the yield (as a factor of the income on offer relative to the price paid) will rise.

Likewise, if maturity is growing closer, yields may drop as the likelihood of a default before maturity decreases – and demand for the bond increases – driving the price up (and consequently driving the yield, relative to the price, down).

Don’t worry if you think this is complicated. Everybody does. You can read more about bonds here.

Or visit DIY Investor’s Fixed Income page here

To learn about retail bonds visit: