Bonds are loan
certificates issued by a government or company
to raise cash, and the issuer pays interest at
a fixed rate. They are the obvious way to diversify
from equities because they are much less risky,
and have had long spells of moving in the opposite
direction, although more recently this has not
happened. One rule of thumb is to invest your
age in bonds as a percentage of your portfolio.
If you are aged 30, bonds would be 30 per cent
of your portfolio but, if you are aged 50, it
would be 50 per cent. You can buy bonds from some
online dealers but typically by telephone rather
than online.
The safest kind of UK bond is issued by the government,
and is known as a gilt-edged stock or gilt. Gilt
prices tend to go down when interest rates go
up because investors in gilts can get better returns
elsewhere. Gilts are repaid at their nominal value,
and the price moves towards this level as the
redemption date approaches.
Gilts are categorized under Shorts (under 5 years
until maturity), Mediums (5–15 years) and
Longs (over 15 years), as well as Undated (no
fixed redemption date) and Index-linked, which
pay a coupon and capital redemption adjusted for
inflation according to the Retail Prices Index,
and are for risk-averse investors. The longer
dated the gilt is, the more its price will tend
to fluctuate in line with interest rate changes.
The current yield is the annual interest of the
bond, divided by the current price. The lower
it is, the higher the gilt price will be, and
vice versa. The gross redemption yield is widely
used to compare returns on bonds. It is the current
yield plus any notional capital gain or loss from
the current date to final exemption. If you buy
a gilt cum dividend, you will receive the interest
payment for the period, and so must compensate
the seller. But if you buy ex-dividend, you will
not receive the dividend.
Corporate bonds work in a similar way to gilts,
but they have a risk of default and so pay slightly
higher interest. Investors in corporate bonds
face price risk, linked to interest rates, as
applies to government bonds, and credit risk,
which is the likelihood that the company issuing
the bond will fail to pay interest or repay the
principal.
