Fixed interest investments is the term used to describe Government and Corporate bonds (which should not be confused with ‘investment bonds’ which are a kind of life insurance policy).
These kinds of bonds are loans to governments or companies that guarantee to pay the bondholder a specified level of income (called the ‘coupon’) for a specified period of time. At the end of that time, the bond issuer will repay the capital loaned.
Role In Investing
Fixed-interest securities are important in diversified investments and investment strategies by:
- Providing a reliable income stream and liquidity
- Providing an element of capital security
The risk of fixed-interest investments is that the bond issuer defaults on either the interest payments or the repayment of capital. Historically speaking fixed interest investments have not provided the same levels of return as equity investments, but the risk to an investor’s capital is generally lower.
As a rule of thumb, the rate of interest offered increases with the risk of the issuer defaulting.
Generally speaking, fixed-interest investments are divided into 3 groups:
Government Bonds
Most governments issue bonds. UK government bonds are called Gilt Edged Stock or "Gilts" and are considered to be some of the lowest-risk investments. Generally speaking, bonds issued by governments represent a lower risk than bonds issued by companies. Consequently, the interest paid by governments tends to be lower than that paid by companies. It must be remembered that one needs to consider the individual government issuing the bonds, as some governments have defaulted on these types of securities or are at risk of defaulting.
Investment Grade Corporate Bonds
These are bonds issued by companies with good financial strength and credit ratings. While generally considered to be riskier than Gilts, they are still low risk compared to investing in equities or commercial property. The rate of interest on these kinds of bonds will normally be higher than that paid on Gilts, but lower than that paid on ‘Sub-Investment Grade Bonds‘.
It should be noted that ‘Investment grade bonds’ can become ‘sub-investment grade bonds’ – at the time of issue the company may have been understood to be on a firm footing but during the term of the bond they may lose their credit.
Sub-Investment Grade Bonds
These are also known as ‘High-Yield Bonds’ or even ‘Junk Bonds’.
These bonds are higher risk than Gilts or Investment grade bonds and tend to pay greater rates of interest. They will normally be slightly lower risk than equities, but will normally be used to provide opportunities for growth and income in a portfolio rather than to provide some capital security.
The amount of risk will depend on the individual company issuing the bond. Companies that are considered to be at a greater risk of default, need to pay a greater rate of interest to attract people willing to lend them money, thus the rule of thumb is that the greater the risk of default, the greater the rate of interest, or ‘yield’ (and vice versa). This gives rise to the common term of ‘high-yield bonds’.
The term ‘junk bonds’ can be used to describe any ‘sub-investment bond’, but is most commonly reserved for bonds of those companies who are already, or are in imminent danger of, defaulting or having to restructure the company and/or debt.
All fixed-interest securities can be traded on stock markets. They may be sold on these markets at a value that differs from the issuer's value. If an issuer of bonds has become more attractive (e.g. the company’s fortunes have improved and/or the rest of the market is considered to be riskier than before) then you may be able to sell the bonds for more than their face value. Alternatively, if the issuer has become less attractive (e.g. the issuer is in financial difficulties) then the value of the bond would be less than the face value (assuming a buyer can be found).
