Thursday, September 27, 2012

All about bonds

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Bonds

The other main asset class is Bonds, either Government Bonds (Gilts) or Corporate Bonds issued by our leading companies.

Gilts

Conventional Gilts carry a fixed coupon and a known price at redemption (usually par, i.e. £100). The advantage of Gilts is that they can offer a more attractive rate of return than a Building Society deposit account but again the risks must be considered.

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1) Security of capital - because Gilts are issued by the government they are the safest of all investments in that respect, as the default risk is negligible.top

) Price fluctuation - the risk with Gilts lies in the price fluctuation. Although a bond may be issued at par (100) and redeemed at par (100) for a fixed period (say 10 years) the price can fluctuate in the meantime. Complete security of capital invested can only be guaranteed if the bond is held to maturity.

) Tax treatment - the income received is taxed at source (5%) and higher rate taxpayers are required to make up the difference at the end of the tax year. Capital gains are not subject to tax (up to a large limit) for private investors, but this is a two edged sword. As with all investments that promise freedom from capital gains tax losses are non-allowable.top

Corporate Bonds

These are similar to Gilts, but with a higher default risk. Companies can go bust unlike the government. To compensate for this higher risk a higher return is available in the form of a higher yield. Bonds are graded as to their safety. G7 Government Bonds are all AAA, as are some Supra Nationals such as the World Bank and European Investment Bank. Next in line are AA Bonds, usually issued by large companies, and so on. The Bonds are graded by Rating Agencies such as Moodys or Standard and Poors, and the ratings can change up and own during the life of the Bond. Many Institutions are prevented from owing bonds below the AA rating. A further problem with Corporate Bonds is marketability. Whilst a healthy two-way market exists in the mainstream Government Bonds, this is not always the case for Corporate Bonds, which can be difficult to buy or sell during the life of the bond. Tax treatment is also less favorable than for Gilts, although this is equalized via the higher yield. Corporate Bonds therefore carry greater risk but offer greater return than Government Bonds.top

Index linked Bonds (Gilts)

These are Bonds issued mainly by the Government that do not pay a fixed coupon. Instead the Start up coupon is increased in line with inflation over the life of the bond. Also the proceeds on redemption are calculated to deliver full index linking over the life of the Bond. The main difference between conventional and index linked bonds are as follows;

1) The income stream on index linked Gilts is not predetermined, as we do not know the future rate of inflation, whereas with conventional Gilts the exact amount is known in advance.

) The Redemption value is also not known for the same reason, whereas conventional Gilts redeem at par (100)

The advantage is that the holder is protected against inflation in a way that holders of traditional bonds are not. However this index linking only fully works if the bond is held to maturity. All bonds fluctuate between issue and maturity and index linked bonds are no exception.top

The holders of index linked Gilts receive coupons, which are linked to the Retail Prices Index. If inflation rises then so does the nominal value of the coupon in order to compensate the investor for the erosion of the value of money caused by rising retail prices. The redemption value of the bond is also linked to the RPI.

The longer dated index bonds require a very large move in the price to deliver a significant change in the real yield. For example, to change the yield on Treasury .5% 04 by 1% requires a move in the market price by approximately 4 points. Although this particular bond has a theoretical duration of 1, implying a very volatile bond, this is extremely misleading, as the real yield is much more stable than nominal yields on conventional Gilts.

Coupons are subject to income tax for tax-paying investors. Any capital Gain (inflation uplift) used to be tax-free to all investors but this has now been amended to an indexation tax whereby the gain due to inflation is tax-free. Any gains over and above the rate of inflation are now taxed.top



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