Fixed Interest Securities

Fixed interest government securities and corporate bonds are a very important class of asset, accounting for a significant proportion of the world's investments. This group of investments is usually collectively described as 'loan stock' and there are several different types in common use.
These types of investment are simply loans made by the investor, typically set up for a fixed term for a fixed rate of interest, payable on a pre-defined basis. The loans themselves are defined by a number of factors, but mainly by the institution or body that the money is being loaned to:

• Gilt edged securities (gilts) are loans to the UK Government.
• 'Bulldogs' are loans raised by foreign governments in Sterling on the London Stock Exchange.
• Eurobonds are loans raised by foreign supranationals (worldwide organisations such as the International Monetary Fund), governments or companies on the London Stock Exchange.
• Permanent Interest Bearing Shares (PIBS) and Perpetual Subordinated Bonds (PSBs) are loans raised by UK building societies and banks.

Within each of these investments there are variable conditions such as the method of paying the interest (e.g. on a fixed or index-linked basis) and some may even turn into a different type of investment at a later fixed date, i.e. convertibles.
It is common practice for the name of the investment to reflect a number of key facts about it.

Investment returns
Fixed interest investments can provide both income and capital growth.

Income
The income element of the return is based on the nominal (or face) value of the investment and hence the loan in question:

• For example, gilts can be purchased in any nominal amounts from 1p upwards.
• However, typically the minimum nominal purchase of the investment would be at least £100 (the nominal price is the amount of 'loan' being made). The cost of buying this investment could be more or less than £100 depending on economic conditions.
• The main point about the nominal value is that it tells us how much interest will he paid. A nominal £100 of 6% Treasury Stock 2028 would pay interest of 6% on the nominal value, or £6.00 per annum. Gilts typically pay half of this every six months.
• This interest payment is often referred to as a 'coupon' due to the fact that, historically, they were claimed by tearing off a coupon and giving it to the issuer in exchange for the interest payment.

Capital
Loan stock is usually repaid at the nominal or face value at the end of the term. Let us assume a nominal value of £100:

• If the actual cost was above £100, there will be a capital loss on maturity.
• If the original cost were £90 then this would result in an increase in the value of the capital.
• It is the prevailing interest rate compared to the stated interest rate on the loan stock that will affect the value of loan stock:
• if interest rates generally rise, the return from the loan stock seems less attractive and the price will fall;
• if interest rates generally fall, the return from the loan stock would seem more attractive and the price will rise.

Where a gilt or other loan stock is purchased at issue at £100 or at a slight discount and held to maturity at £100, there will have been no loss in capital for the investor:

• With gilts, this transaction would be described as `no risk' as the value of the capital is effectively underwritten by the Government.
• If the loan is issued by another body, there is still a risk that they may not repay the loan (called a credit risk).

In summary, gifts held for their lifetime have no risk to capital and gilts that are 'traded' during their lifetime may not return the full capital and would be described as low risk investments.

Gilts
Gilts are fixed interest stocks issued by the UK Government. As such, gilts are considered to be the safest assets of this type. This is both good news and had news from the investment perspective: good news because the risk to the capital is relatively low, but bad that this lower risk brings with it a lower reward (return). The lower risk means that the yields (income/capital cost) are lower than other assets in this class.

Gilts are usually issued in nominal units of £100. However, you should note that the buying price will often be quite different.

The name of the gilt will provide significant information about it:

• The first part states the rate of interest payable based on the nominal value of the stock.
• The second part identities the Government department issuing them (Treasury, Exchequer), what they are (funding stock, War Loan etc.) or where the debt came from (consolidated stock, conversion stock etc.).
• The final part provides the year, or in some cases years, that the loan will be repaid.

Gilt interest rates
The 'nominal' interest rate quoted in the name of a gilt is very relevant to the investment returns produced by this asset class. However, there are two other figures that can provide us with more information, namely:

• running yield; and
• redemption yield.

Let us examine these three interest figures in more detail.

Nominal yield
The nominal interest rate will allow us to make certain deductions:

• If the nominal yield is greater than the prevailing market interest rates, the cost of buying the gilt will be more than £100 per £100 of loan: sometimes described as being 'above par'.
• If the nominal yield is less than the prevailing market interest rates, the cost of huying the gilt will be less than £100 per £100 of loan: sometimes described as being 'below par'.
• Where the nominal yields are similar to the prevailing market interest rates, the cost of buying the gilt will be about £100 per £100 of loan: sometimes described as being 'at par'.

This information also tells us the potential for capital gain or loss on a transaction.

The price of the gilt reflects the combination of the return in income and capital terms. In this case there is a capital loss, so the income returns must be higher to compensate. In times when prevailing interest rates were higher, gilts trading 'below par' could produce a gain in capital at redemption. Therefore, the interest rate would he lower than prevailing rates to offset this.

Running yield
As we have seen, although we can derive information from the nominal yield, it is of little use in its own right. A more useful measure of the interest rate is the 'running yield'. This takes the nominal rate and compares it to the price paid for the gilt.
In summary, the running yield is a reasonable guide to the ongoing rate of return on the investment, but not the total return.

Redemption yield
The redemption yield makes allowances for both the income and the capital. It is a complex calculation involving internal rates of return.
The price offered for the gilts reflects the value of the investment return they give, whether this is made up of income or capital.
The redemption yield is the figure that could be used to compare a gilt to a completely different type of investment, such as a building society account or a premium bond.

Name of the issue
The name of the issue indicates the body that has issued the fixed interest investment. In the case of gilts, it will be the Government department or purpose for which the loan was issued e.g. Treasury, Consolidated, War Loan etc. In the case of other fixed interest investments it will be the institution issuing it, e.g. SAINSBURY(J) 6% NOTES 5/4/32 GBP. The credit-worthiness of the issuer is of particular importance to analysts of fixed interest stocks as this will reflect on their ability to repay the loan at maturity.
Maturity date of the issue
All fixed interest investments are classified by the number of years to run to maturity:

• The official Bank of England classifications refer specifically to gilts, but are as follows:
• Shorts: 0-7 years left to run.
• Mediums: 7-15 years.
• Longs: Over 15 years.
• Undated: No fixed repayment date.
• You will often find 'shorts' referred to as up to 5 years and mediums as 5-15. Certainly, these are the typical timescale descriptions for all investments.
• The dating of gilts in this way allows financial planners to tailor purchases with particular planning needs, such as 'mediums' for school fees planning and 'longs' for retirement.
• Some gilts have a range of repayment dates, such as 2012-2015. This means that the Government can choose to repay at any time from 2012 onwards with three months' notice, but must repay it by 2015 at the latest. Note that it is the Government, not the investor that decides which date is used.
• Undated gilts are often issues that once had a date and usually some additional small print to the effect of 'on the maturity date or at some later time if necessary'. An example of this is the 3.5% War Loan' which actually had a redemption date of 1951 or later, but which ultimately became undated. With an interest rate payable of 3.5%, it was not in the Government's interest to repay the loan and it has therefore remained extant.

Index-linked fixed interest investment
A number of issues of fixed interest stocks are index-linked, with both the interest and capital value linked to the Retail Price Index (RPI). In the UK, most index-linked fixed interest investments are issued by the government as gilts, but a few are issued by other financial institutions. Index-linked stock is a rarity outside the UK, but is becoming increasingly popular.
Ultimately, index-linked investments such as these seem to answer the problem of inflationary risk. Certainly, by buying them investors can ensure that they receive returns over and above inflation in both capital and income terms. However, the situation is a little more complex than this. As always, there will be a balance of value between a stock paying, say, 2% above inflation, with inflation at, say, 2.5% and a normal fixed interest stock paying 5%.
As an example, the UK 2.5% 2016 index-linked gilt has a break even inflation rate of 2.99%. If you, as an investor, feel that inflation will exceed this level during the relevant period then it would be better to purchase this rather than a conventional gilt as the investment will yield a greater return.

Buying fixed interest investments
Fixed interest investments can be purchased at issue from the issuer. This can be a good way of buying as the investments are purchased at face (nominal) value and there are no additional costs involved with the purchase.
They can also be purchased via the stock market through a stock broker. In this case it is stock that has already been issued that you are buying. This means that the price you pay will not be the same as the face (nominal) value and you will have to pay commission to your stockbroker, adding extra costs and expenses.
While gilts are simply fixed interest investments issued by the Government, there are slight differences in the method of purchase. There are two ways of buying gilts as an investor:

• New, as issued by the Debt Management Office (DMO), a Government department.
• 'Second-hand', via the London Stock Exchange through a stockbroker or via the Bank of England's brokerage service.

Foreign government loans
The London Stock Exchange is one of the largest exchanges in the world for loan stock. One of the reasons for this is a tax exemption on the interest payments for bonds traded on the exchange, making it a popular choice for investors and those seeking to raise money.
Foreign governments may raise money in their own currency (or any currency other than Sterling) via Eurobonds, or they may raise money in Sterling via 'Bulldog' bonds.
It is important to bear in mind that the investment risk with this type of investment is whether the issuer is able or willing to meet the interest and capital repayment commitments:

• The more risk that payments will not be met, the greater the investment return required by the investor.
• For this reason, the yields on bonds issued by some governments are much higher than others.

Corporate bonds
Supranational organisations may span many different countries and receive a proportion of their underlying funding from each, but a number nt them still need to borrow money. This is done by issuing loan stock, usually in the form of a Eurobond and, less frequently, a 'Bulldog'.
Companies based in the UK, elsewhere in the world and those whose operations may span several continents, make use of the London Stock Exchange to raise money. Again, it is the perceived credit rating of the company that will dictate the risk of default and hence the level of interest that must be paid by the investment for it to be considered good value.
The three main types of corporate bond are:

• Loan stocks: can be secured on the overall financial strength of the company, a specific asset or may even be unsecured.
• Debentures: effectively loan stocks with specific terms and conditions applying to the loan.
• Convertibles: stocks which may be converted at a predetermined time in the future to a predetermined number of 'ordinary shares' in the company.

Loan stocks
Loan stocks may be secured or unsecured.
Unsecured

• In the event of a company becoming insolvent, loan stocks will rank behind HMRC and other secured lenders.
• As a result, ordinary loan stocks carry a higher risk and must therefore compensate the investors accordingly.

Secured
The security may be:

• a general charge over company assets;
• a specific fixed asset.

The security given will influence the security of the loan.

• Fixed assets. Where a loan is secured against a specific asset, this will be identified in the documentation of the loan note. In general, the interest rates paid on this form of loan are lower due to the reduced risk of default. In the event of insolvency, the loan holders will be repaid after HMRC, providing that there arc no other claimants against the security.
• General assets (floating charge). A loan secured by a floating charge is safer than an unsecured loan, but not as safe as a loan secured on a specific asset. The loan holders rank behind HMRC and other loans secured against specific assets, but they do rank ahead of unsecured lenders. Interest rates on this form of loan are typically higher than those loans secured on a specific asset and lower than an unsecured loan.

Bank and building society loans
Building societies issue a form of fixed interest investment, a PIBS. PIBS are very similar to the other fixed interest investments we have discussed except:

• they are undated;
• interest payments can be missed in exceptional circumstances;
• missed interest payments do not need to be made up at a later stage.

This makes this type of investment higher risk than other forms of loan stock. However, as a result they do tend to produce higher rates of return.
Where a building society has been `demutualised’, PIBS become PSBs:

• Perpetual: as they have no redemption dates.
• Subordinated: as they arc a low ranking debt for repayment in the event of insolvency.
• Bonds: as this is a general name for fixed interest investments.

Taxation of fixed interest investments
For private investors, the capital gains made on the buying and selling of fixed interest investments is exempt from Capital Gains Tax (CGT). This is reasonable considering the majority of the investment return from this asset class is in the form of interest which is taxed. However, any capital loss on a gilt cannot be offset against other gains.
There is an exception to the above rule for a special type of fixed interest investment, called a 'deep discount bond'. This provides a large proportion of its return in the form of capital gain at the redemption date rather than from periodic payments of interest. HMRC apply special rules to this type of security and tax any profit on sale or redemption as income in the tax year of disposal rather than charging CGT.
The interest from fixed interest investments is payable gross but is subject to tax at the savings rates. Corporate investors are subject to corporation tax on income and gains.

Examination of the risks and rewards
As an investment, fixed interest bonds are relatively simple:

• They are loans made by the investor to the issuer.
• In return, an agreed amount of interest is paid.
• The loans may be for a fixed or indefinite period.
• The interest payable may be clearly defined (e.g. 6% per annum payable half-yearly) or may be linked to another form of return, such as inflation (as with index-linked bonds) or an interest rate (e.g. 2% above London Inter Bank Offered Rate (LIBOR)).

As a loan, a fixed interest investment is only as safe as the institution that borrows the money and its ability to repay:

• To make an assessment of this risk easier, there are a number of agencies which assign credit ratings to different forms of loan stock.
• Some loan stock will be of investment quality (AAA), whereas others could be 'junk' or below investment quality (below BBB).
• The higher the credit rating, the lower the investment (redemption yield) is likely to be.
• Gilts are the lowest risk investment and may be described as `no risk' if held to maturity or 'low risk' if bought at a price 'above par'.

As an asset class, fixed interest investments have historically performed better than deposit investments but not as well overall as equities (shares).

Use of fixed interest investments
Although fixed interest investments rate as `low risk', it is fairly unusual for individuals to actively seek them out as an investment medium in their own right. They are a specialised form of investment and, although 'amateurs' can get good returns, most investors would be best advised to leave it to investment managers who specialise in that field.
One of the best ways to access fixed interest investments is via investment funds such as unit trusts, Open Ended Investment Companies (OEICs) or life assurance and pension funds. In this environment they are managed by professionals. As the funds are not necessarily held to maturity, such funds are often categorised as low risk, although care must be taken.
It is becoming more common for funds to be based on the higher risk 'junk bonds', where the higher returns are balanced against the proportion of loans that do not get repaid. The risk of capital loss with a junk bond fund can be significant.

Short-term use
For investments over the short term (up to five years) fixed interest investments can perform a number of roles. As a low risk investment, they can be used directly or as pooled funds to provide for short-term savings or to produce income.
Potential uses

• Savings: for holidays, school tees, weddings etc. with a view to capital preservation over the short term.
• Income: they can provide a useable income for help with school fees or other fixed commitments.
• Pensions: for capital preservation where there is a short period of time to retirement, fixed interest investments are more reliable than equities and many professionals switch a proportion of their clients' pensions to fixed interest funds as retirement approaches.

Medium-term use
For investments over the medium term (5-15 years), fixed interest investments can be used as an investment in their own right with a very useable income. However, they will often form part of a broader strategy.
Potential uses

• Savings: for holidays, school fees, weddings etc. with a view to capital preservation over the medium term.
• Income: they can provide a useable income for help with school fees or other fixed commitments such as providing an income in retirement, either directly or via collective investments such as unit trusts and ISAs.
• Income from purchased life annuities: made possible for life companies by the use of fixed interest investments as the underlying asset.
• Pensions: often utilise 'lifestyle investments' which involves a pension investment strategy that uses increasingly larger proportions of fixed interest investments as retirement approaches.
• Asset allocation: an asset class in their own right which can be used in conjunction with deposits and equities to 'diversify' a medium-term portfolio.

Long-term use
Fixed interest investments are used in a number of long-term investment situations.
Potential uses

• Pensions: long-term gilt and other fixed interest investments are the underlying asset for retirement annuities.
• Income: as age increases and the risk tolerance of an investor reduces, there is an increasing need for an asset that can provide an income with a very low risk to capital and fixed interest investments can achieve this.
• Income: PEP and ISA investments can be invested in equities or fixed interest investments. As investors get older, less risk tolerant and require higher levels of income, the balance can be moved more in favour of the latter.
• Asset allocation: effective long-term investment portfolios need to be diversified over all asset classes, including fixed interest investments.

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