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investment funds
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Gilts
These are contracts whereby a large body (a corporation or Government) asks to borrow money on the basis that it will then pay X% pa for a period of time, and then repay the capital. They are a debt issued by that body. Think the reverse of a mortgage. Contracts issued by the British Government are called gilts.
For example a £1 Billion bond paying 7% until May 1 2018.
If you are one of the people who take the bond when it is launched, the maths is easy. If you invest £100,000, you get £7,000 a year until May 1 2018 and then you get your £100,000 back.
But now it gets tricky. Stop thinking about 7%, but instead think about buying an income of £7,000 pa until May 1 2018. Once the bond starts trading in the market everyone pretty well ignores the 7% figure. It becomes irrelevant. What matters is the £7,000, and just how much would you be willing to pay for an annual income of £7,000, followed by a lump sum of £100,000 on May 1 2018. (The current price of the bond will show the present market view).
The answer to this depends largely on the inflation and interest rate outlook at the time that you are thinking of buying. If the outlook is bad you might not want to offer more than £80,000. If the economy is doing well, with low inflation and interest rates, you might pay £120,000.
Which brings us to a discussion of the risk of bonds.
They are normally described as lower risk investments, which can be true, depending on the issue i.e. Government bonds are low risk but corporate bonds may not be, depending on the rating of the issuing company. Bond funds are funds run by investment companies, and they may hold a number of bonds at any one time. Differing levels of risk are available depending on the composition of the fund. They may be fairly passive, holding bonds to maturity and then reinvesting the proceeds, or they may be aggressive traders in the market, or a mixture of the two.
Risks
The big, but most unlikely, risk is that the body issuing the bond goes bust. Where the bond is issued by a financially stable Government this is obviously very low, and most larger companies are also safe, but companies (which issue corporate bonds), even big ones, can and do go bust, and bondholders have no special protection.
So on this basis if you buy a bond (whether at outset, or in market) you know what your return will be IF you hold it to the end of the bond's life, and given that bankruptcy is unlikely, this can be considered a low risk investment.
But if you buy the bond for £120,000, and sell it three or four years later for £80,000 you have made a big loss. This means that trading bonds (buying with a view to selling later for a gain) is not a low risk activity.
Very few investors actually trade bonds on their own account, but they do invest in bond funds (or corporate bond funds), and sometimes they do so thinking that such funds cannot fall. This is of course wrong.
There are plenty of good reasons to invest in bond funds, the two most common being for income, and/or to spread your money across a range of investments in order to minimise your overall risk, but it is essential that you make such investments with an understanding of the risks. We can discuss bonds and bond funds in more detail if you ask us.
Last updated on April 06, 2012