This article was originally published here in December 2002
With the falls in the stock market investors have looked for different, less risky, investments. Many have chosen to invest in government gilts or corporate bonds, either directly or through unit trusts. Whilst the income from government gilts is certainly secure the same cannot be said for corporate bonds. With both types of investment the capital invested may not be as secure as many people think.
A bond is effectively an IOU that usually pays the holder interest. A company issues corporate bonds, whilst gilts are issued by the UK government. Both usually pay a fixed rate of interest and return the capital invested at some fixed future date. The most important fact to note is that the price of a bond moves inversely to the current interest rate. As interest rates move up the price of a bond declines (and vice-versa, of course). The ideal scenario for an investor is falling interest rates. As well as the interest payments from their investment the capital value grows too.
You should understand that the rate of interest paid on a bond is related to the perceived risk of the bond. A UK government bond is very secure so pays a low rate of interest. A corporate bond from a company in trouble will pay a very high rate of interest to encourage investors despite the risk of the bond defaulting. A high yield fund targets these speculative bonds and attempts to reduce the risk by investing in a large number of bonds, the theory being not all can fail. Lower yielding bond funds invest in more reliable companies.
Back in the early ’90s I was a student at university. I was looking for a secure place to invest my small cash savings. Gilts fitted the bill; they paid a good rate of interest without tax being deducted at source. They could be purchased cheaply through the Post Office. These days you can buy gilts directly from the Bank of England. Interest is still paid without tax being deducted. Another advantage of gilts over corporate bonds is that they are free of capital gains tax, although that did not concern me back then.
In April 1991 interest rates were 12½% but I expected them to fall. The gilts that I bought were "2½% Consolidated Gilt Stock", an unusual gilt that does not have a redemption date. These undated gilts are ideal for speculating on interest rates. Although the nominal interest rate was 2½% I only paid just over £25 per unit giving me an effective interest rate of just under 10%. As the UK base interest rate was 12½% you can see that the market was expecting a decline in interest rates and marking down the price of gilts.
Over the next year interest rates did fall to 10½%. By then I decided that the small capital gain that I had made was enough. As a student, I had much better things to spend it on. With the interest and the capital gain my investment had returned 12%.
There is one word that strikes fear into a fixed interest investor. "Inflation". It erodes the value of both the interest payment and the final capital return. In my case the purchasing power of the pound declined by 5% during the term of my investment reducing my real return to 7%.
As a child I was dragged around many stately homes and ancient churches. Although I cannot recall where it was I do remember reading a plaque on a church wall to some local squire who "left in his will £200 in consols (an old form of undated gilt), the interest from which should be spent on the poor of the parish". A couple of hundred years ago the few pounds of interest would have kept many poor people from starving but today it hardly buys a single meal. A more recent example is the hyper-inflation in Germany in the early 1920’s. Anyone relying on fixed interest investment would have been destroyed. Although the days of high inflation seem to have passed I reckon anyone who is reliant on income from investments should consider putting some of their money in "Index-Linked" gilts. Here the interest and the capital repayment are increased in line with the Retail Prices Index, the Government’s inflation measure.
In the past I have profited from a capital gain on my gilts in addition to the interest payments. However, with today’s low interest rates I think the opportunity for profits has passed and the next move in interest rates will be up. If that turns out to be true, anyone buying a gilt or bond today will suffer a capital loss. The interest rate paid by gilts is matched by the dividends available from many blue-chip shares on the stock-market. These shares still offer the possibility of a capital gain at a higher risk; their value can fall to zero. Next month I will explain about another form of secure investing that I am using and why I think it is better than bonds.