Financial Services > Investments > Bonds

 


The term Bond could actually be replaced with the word 'loan'.


There are a wide variety of Bonds issued by governments, businesses, local authorities and investment institutions, and a description given to the income flow from those Bonds is the 'coupon'.

The coupon is paid gross and so you must inform your accountant or Her Majesty's Revenue & Customs of any payments that you receive.


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But before we look at Bonds, let us first deal with the Bond that is not a Bond - the Capital Investment Bond that is offered by insurance companies.

Much confusion surrounds this type of investment because it is actually a single premium whole of life insurance policy and not a Bond at all.

Those investments have a little bit of life assurance built into it and your money can be invested in a wide range of assets (including Bonds, curiously) but the proceeds will be subject to Income Tax through an obscure mechanism known as Chargeable Events.

There are lots of occasions when this type of investment is ideal, but it should never be confused with a real Bond.


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You will of course be familiar with the concept of borrowing money.

If the lender thinks that you are a risky proposition then the interest rate goes higher and higher, and the same thing is true of Bonds. If the government of France wanted to raise money through the issue of Bonds it is a relatively low risk loan, but the same could not be said for Iraq, to quote an extreme example.

Great care is needed when choosing the individual Bond or the collective investment scheme of Bonds that is right for you. Every Bond issue is given a credit rating both at the point of issue and throughout the duration of the loan.

Please remember this when looking at the past performance of investments, because the best performers have usually taken the biggest risks and so it would be incorrect to assume that investing in Bonds will always carry a low degree of
risk.

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There are some curious risks attached to the Bond market that you may not anticipate.

For example, if you buy a Bond when it is issued, keep the Bond until it is due to be repaid and all of the coupons are met in full, everything is quite straightforward. However, most people do not invest in this manner and tend to buy 'second-hand' Bonds on the market or a wide selection of Bonds through a collective investment.

In such circumstances the price paid to buy the investment will bear no relationship at all to the face value at which the Bond was issued and will eventually (hopefully) be repaid at.

Let us assume that when the Bond was issued a fair rate of interest was 8% and that the borrower is still regarded as being trustworthy. If the normal rate of interest on cash deposits is 4% today, then owners of that Bond can sell it in the open market for more than the face value. In effect, the price paid by the buyer will be such that when all of the remaining coupons are taken into account, they still achieve a better return than the 4% available from ordinary cash deposits. The seller obviously benefits from an instant profit (known as a Capital Gain).

The converse is equally true, that if you held an investment where the coupon at the date of issue was fair at 4% and the prevailing rate of interest on deposits was now 8% then the value of the investment in the open market is much less than the face value of the Bond.

What this means in practice is that when interest rates rise Bond prices fall and vice versa.