The name bond is used for many different types of investment, ranging from the premium bonds given as presents by godparents to complicated instruments linked to the performance of the stock market. Your bond might be designed to provide income, capital growth or a combination of the two. It might even throw in a guarantee or two for good measure.
In the City bonds are really only considered to be one thing - fixed- interest securities. Together with cash and shares, they are one of the three main categories of investment that make up an investment portfolio. A fixed-interest security is a loan made by the investor to a government (known as gilts in the UK), local authority or company (called corporate bonds). The issuer of the bond repays the debt after a set period, although some bonds have no fixed repayment date. During the life of the bond the borrower also promises to pay a predetermined amount of interest.
Fixed-interest securities are traded on the stock market, and the market price will vary. This means these bonds are a risk investment: you may get back less than you paid, but if you hold the bond until its maturity date you know exactly what you will get back. If you paid more for the bond than its redemption value you will make a capital loss if you hold it to maturity. If you paid less, you will make a capital gain.
When interest rates rise, fixed-interest security values tend to fall. Investment is about relative attractions. When interest rates rise, building society deposits tend to increase the interest they offer. They then look more attractive compared with bonds, whose interest remains fixed. Consequently investors tend to shift out of bonds, depressing their prices and in turn increasing their attraction again.
Fixed-interest securities are considered lower risk than shares, and suitable for people who want a higher investment income. You would not normally expect to get capital growth as well. If you do make a capital gain, it is likely to be tax-free, in part because most bonds are free of capital gains tax. But interest payments are liable to income tax.
Traditionally, the part of the bond market most used by private investors is the gilts market. Gilts are issued by the UK government to finance its debt. But corporate bonds have come more to the fore recently because they can now be held in tax-free personal equity plans. Corporate bonds are IOUs issued by companies. Most work much like gilts, with a fixed repayment date and fixed interest payments. But some have different characteristics. For example, convertible loan stock and convertible preference shares carry the right to convert the investment into the ordinary shares of the company that issued the debt. Beyond the high financial markets, bonds are different animals. There is a whole range of bonds sold or underwritten by life insurance companies.
Many are termed investment bonds, and are also called insurance bonds and single-premium bonds. They can cover a range of investments and normally incorporate a life insurance policy. There is no basic-rate tax to pay on the investment returns but that does not make-them tax-free. Basic- rate tax is paid by the life company running the bond. Non-taxpayers cannot reclaim the tax. Higher-rate taxpayers are liable for extra tax, but they can postpone it.
Special rules allow investors in many of these bonds to withdraw 5 per cent of the initial investment each year without paying higher-rate tax at the time. The rules can be complicated and it is best to seek advice from a financial adviser.
Most of these investment bonds are risk investments. Moreover, for investors prepared to take this risk, the superior tax advantages, lower charges and greater flexibility offered by PEPs will usually make them more attractive than an unPepped bond investment.
With-profits bonds are one form of life-insurance linked bond. Like with- profits endowment policies used for mortgages, your money goes into a fund which invests in a range of assets from shares to commercial property. Bonuses are added each year, but read the small print carefully. Some companies make a "market value adjustment", depending on when you cash in the investment. It can reduce the bonuses awarded. Towry Law, a financial adviser, offers free copies of its With Profit Bond Survey. Call 0800 521196.
Distribution bonds are aimed at investors seeking a regular income, although there is the possibility of some capital growth. The bonds invest in a mixture of equities, fixed-interest securities and, in some cases, property. Their aim is to provide a relatively stable but not fixed income while maintaining the capital value of investors' money.
Guaranteed stock market bonds, which usually offer life insurance as well, have become fashionable in recent years. Typically, they guarantee all or most of your original investment back after five or so years, in the unlikely event that the stock market falls over the period. If the stock market rises, you get a guaranteed return linked to the rise in a stock market index such as the FT-SE 100. A unit trust designed to track the movements of the FT-SE 100 and placed in a tax-free PEP could be a better option.
Guaranteed income and growth bonds are for investors who want a guaranteed and fixed return with no risk to their original money. They can last from one to 10 years. The best are paying 7 per cent net of basic-rate tax. Income bonds pay you the fixed return as an income; growth bonds roll up the income and pay it all out with the return of your original investment when the bond matures. Baronworth Investment Services, a financial adviser, offers to send readers copies of its best buy tables for guaranteed income bonds. Call 100 and ask for Freephone Bondline.
Building societies also offer a range of bonds, most aimed at providing a fixed level of income for a period of time while also guaranteeing the return of your original capital. Building society escalator bonds are fixed-rate deposits where the rate of interest rises each year. With escalator bonds, find out the average annual fixed rate and compare it with the annual rate on other fixed-rate bonds. Fixed-rate or escalator bonds could be attractive if interest rates are about to fall, but you could do badly if interest rates subsequently rise. There are usually heavy penalties if you cash in early.
Premium bonds are issued by National Savings and have a minimum investment of pounds 100. You earn no interest, but have the chance to win prizes of up to pounds 1m, winners are picked by Ernie the computer each month. You can get back your original investment at any time.
National Savings also issues a range of other bonds, available through post offices. These are broadly comparable with building society deposits. Most have fixed rates of interest, although income bonds have a variable rate.
o Our table of Best Savings Rates on page 14 covers a range of deposit bonds.