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Income and Growth Survey: The Name Is Bond

STOCKMARKET VOLATILITY, such as we have seen in recent months, makes investors wary. Rather than punt their cash directly into equities, they are seeking alternatives that will provide higher returns than from a building society account, but without too much risk.

Bonds can be part of a low-risk investment strategy. In essence, they are "loans" of capital by the investor to a private company, the Government, or some other official body. Bond owners will receive regular interest on their savings, plus the repayment of the original investment.

Unlike a typical building society account, the rate of interest of a bond is fixed at the outset, guaranteeing a certain level of income.

Most bonds will have a fixed life, particularly Government bonds, or "gilts". At the end of that life - which could be just a few years or up to 30 years away - the original capital will be repaid by the company or official body which had borrowed it. A few gilts, known as "irredeemables" are undated.

Gilts with less than five years left to run are called "shorts", those with five to 15 years left are called "mediums", those with more than 15 years are known as "longs". While you cannot cash in a bond for its redeemable value before the repayment date, it can still be sold on the stockmarket. It becomes a "tradeable security".

Interest paid on gilts is known as a "coupon". It is fixed for the life of a gilt. The coupon, usually paid twice a year, depends on whatever rates of interest are in place at any moment, plus the borrower's financial strength. For example, gilt rates are lower than those paid by private companies on their bonds. This is because most people assume the Government is less likely to default on the loan.

While a gilt can have face value, this may not necessarily be the price that you pay for it. Bond prices can go up or down, depending on a range of factors. One of those is the level of interest rates. When interest rates rise, the price of a bond falls and vice versa.

This is because a bond paying a coupon/yield of, say, 5 per cent will become less attractive if interest rates rise to 6 per cent. Alternatively, should interest rates fall to 4 per cent, a bond paying more than that becomes more sought-after. The lesson to be learnt here is that the current yield, based on the price paid for a bond, is more important as an indicator of income than the coupon.

Equally important, assuming that you keep a bond until maturity, is its redemption yield. This is the term used for the earnings received from the interest paid to you, plus losses or gains on the capital invested when the bond is redeemed.

There are many different types of bonds:

n Gilts are bonds issued by the Government. They are considered among the safest form of investment.

n Index-linked gilts, which are also issued by the Government, differ from conventional gilts because payments they make are linked to inflation.

n Corporate bonds are issued by private companies which offer a certain rate of interest to investors. A company's bonds are assessed by credit rating agencies.

n High yield corporate bonds, otherwise known as "junk bonds", are an extension of corporate bonds. They pay a higher yield because their credit rating is lower.

n Preference shares have no redemption date. They pay a fixed dividend. They are perceived as being higher-risk than ordinary corporate bonds.

n Convertibles provide the option of converting into the ordinary shares of a company. They too pay a fixed rate of interest per share - up to the moment of conversion.

n Floating rate notes (FRNs) are securities typically issued by banks. They offer a rate of interest fixed for three months. The rate is higher than from cash deposits.

n Treasury Bills are short-term securities issued by the Government. They usually have a maturity date of just three months.

n Certificates of deposit are issued by both banks and businesses. They are deposits that can be bought and sold in the stockmarket.

n Zero-coupon bonds do not pay interest, but are issued at a large discount to their face value, so a return comes in the form of capital gains.

n Permanent interest bearing shares (PIBS) are issued by building societies, and are effectively shares in that society. They have no redemption date.

Nic Cicutti