SAVINGS & INVESTMENTS

Fixed Interest Investments

IOUs issued by governments and businesses

Fixed Interest Investments

Fixed interest investments, also called bonds, are essentially loans issued to governments or companies. They should not be confused with ‘investment bonds’, which are a type of life insurance policy.

When you purchase a bond, you lend money to the issuer. In return, they commit to paying you a fixed income, known as the ‘coupon’, for a specified period. When this period ends, and the bond ‘matures’, the issuer returns your initial capital. Although the coupon payment remains fixed, the bond’s price can be traded on secondary markets, where its value will fluctuate.

Key concepts in bond investing

Credit Risk: The risk that the issuer defaults on its coupon payments or fails to repay the capital at maturity. Credit rating agencies assess this risk, assigning ratings to issuers.
Interest Rate Risk: Bond prices have an inverse relationship with interest rates. If interest rates rise, newly issued bonds will offer higher coupons, making older, lower-coupon bonds less attractive. As a result, the price of existing bonds generally falls. The opposite is also true. A bond's 'duration' measures its sensitivity to these changes.
Inflation Risk: The risk that fixed coupon payments will not keep pace with inflation, diminishing the real value (purchasing power) of your returns and final capital.

Role in a diversified portfolio

Fixed interest securities can play a significant role in an investment strategy. They can offer a dependable income stream, are generally less volatile than equities, and provide liquidity. However, they are not without risk.

Main categories of fixed interest investments

Government bonds are issued by most governments to finance public expenditure. UK government bonds are called 'gilts' and are generally regarded as among the lowest-risk investments because the UK government has a very strong credit rating. Bonds issued by stable governments usually offer lower yields than corporate bonds.
Investment-grade corporate bonds are issued by companies with strong financial health and a good credit rating. Although they carry a higher risk of default than gilts, they are still regarded as relatively low-risk compared to equities. In exchange for this increased risk, they generally offer a higher yield than government bonds. A company's credit rating can be upgraded or downgraded over time depending on its financial performance.
Sub-investment grade bonds (high-yield bonds), also known as 'junk' bonds, are issued by companies with weaker credit ratings. They carry a significantly higher risk of default but compensate investors with much higher coupons. The general rule is that the greater the perceived risk, the higher the yield required to attract investors. These bonds are often used to seek higher income or growth, rather than for capital security.

Valuation, dealing, and costs

Individual bonds are traded ‘over-the-counter’, while bond funds are typically valued and dealt with daily. All fixed income investments incur charges, whether through trading spreads or fund management fees, which will lower your overall return. For tax efficiency, bonds and bond funds can be held within wrappers like an ISA or a pension.