Friday 28 January 2011

Gilts and Bonds (UK)

No, not that kind of Bond...
The top layers of the Income Pyramid includes government bonds ('gilts' in the UK) and corporate bonds - held in an online tax-protected brokerage account. Buying individual examples of these assets is really only for more experienced investors, although you can use an appropriate ETF to purchase a diversified holding - and gain many of the benefits.

Government bonds/gilts are loans made to the government - and corporate bonds are loans made to businesses. Both classes of assets share similar features; the main difference is that gilts are a lot 'safer', as they are guaranteed by the issuing governmental authority (local or national).
In the UK it can be a bit difficult to find information on these investments - see the 'Toolbox' tab above for up-to-date sources.

The key data you need to look at includes:
  • the ask price (i.e. cost to buy)
  • the 'coupon' or income yield (rate of return, year on year)
  • the gross redemption yield (rate of return if the stock is repaid)
  • in some cases, the 'call'/no 'call' rate (where the security may either be redeemed or the coupon reset

There are two broad types of gilt or bond - dated (i.e. with a repayment date identified) and perpetual (with no repayment date). Both will be relevant to the DIY Income Investor.

Perpetual Stock

Taking two examples of perpetual stock (at today's date)
  • gilt reference CN4 (Consols, 4%) has a cost of 78.70p and an income yield of 5.13%
  • bond reference EHS5 (HSBC 8.208%) has a cost of 107.7p and an income yield of 7.76%
Both these stock have a yield (rate of return) higher than any available cash savings account (or cash ISA), with the bond yield looking very attractive.

However, with higher returns come greater risks:
  • the price of the stock is affected by the expected interest rate in other investments; if interest rates go up (for example, the Bank of England raises interest rates) the price of these stocks will fall. Although you would continue to receive the same amount of income, if you sold the investments you would make a loss
  • for corporate bonds, there is a risk of default and losing all your money (however, this risk is generally considered to be pretty small for the FTSE 100 companies)

However, another way to look at it is that these 'perpetual' stocks could provide the basis for a continuing, reliable income stream for many years. The possibility that you might not get back all the price you paid for them is only relevant if you think you will actually have to sell them. As stock markets wax and wane there are sometimes opportunities to 'lock in' very good rates of return to be enjoyed over many years.

Dated/'Callable' Stocks

Dated stocks have a redemption date, when the capital amount (not necessarily what it cost you to buy) will be repaid (for 'callable' securities, the issuer has the choice of redeeming or resetting the coupon). These stock are therefore a bit like fixed-interest cash bonds: you know how much they cost, what the annual income (or coupon) will be and when you will receive the capital back. The great advantage over cash bonds is that holding these dated stocks in an ISA will mean that there is no tax liability. The only constraint in using an ISA is that the redemption rate must be at least 5 years in the future (you can still sell them before then, of course).

Because the cost (and yields) change over time, there are sometimes bargains to be had, so it is worth keeping up with the yields available for gilts and corporate bonds.

I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

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