An introduction to fixed term bonds

Posted Aug 12, 2019

A fixed term bond is essentially a form of IOU. To put it more technically, it’s a fixed income instrument that represents a loan made by an investor to a borrower - typically a business or a government - so that owners or holders of bonds are creditors of the issuer.

The physical bond - the piece of paper - will include the details of the loan, including an end or maturity date when the principal is due to be repaid to the bond owner. It usually also details the terms for fixed interest payments, known as coupons, that will be made by the borrower. These may be paid at fixed, regular intervals, or be rolled up to be paid on maturity with the principal sum. Bonds are used to finance projects and operations.

 

When should you invest into fixed term bonds?

Traditionally, investment funds have included a mixture of the two major asset classes - bonds and equities - to maximise the potential for a smooth return over the medium to long-term. This traditional balanced fund is often used for pensions, where the split is typically 60:40 between bonds and equities.

Putting together a mixture of different types of asset in a portfolio matters because it allows you to achieve the all important element of diversification. Diversifying means not putting all your eggs in one basket. Not only does this entail a spread between equities and bonds, but also balancing investments within each asset class, so that you aren’t exposed too much to one particular industrial or geographic sector. This balanced approach tends to even out the peaks and troughs as various markets rise and fall. It can be the case, for example, that when equity prices fall, bond prices rise - as investors prefer the regular interest payments.

 

What are the risks and returns of fixed term bonds?

It’s possible to diversify within bonds as a class. As we’ve mentioned, there are different kinds of fixed term bonds. Governments issue them – in the UK these are known as gilts – as do local governments and private companies. They can be denominated in different currencies, have different rates and can be;

  • Short term, with between one and five years to maturity
  • Medium term, with five to 12 years to maturity, or 
  • Long term, lasting up to 30 years

Different bonds will carry different degrees of risk. A fixed term bond issued by the government of a developed nation, for example, will have a lower element of risk than one issued by a start-up tech company.

Risk, and its relationship to the potential return, is fundamental when evaluating any investment. The whole point of any investment is to generate a return on capital, but any investment also involves an element of risk. There’s always the threat - however remote - of not getting some or all of your money back, or, at least, of an investment performing significantly worse than anticipated.

As a rule of thumb, the better the potential rate of return that an investment offers, the higher the risk is likely to be. So, putting money in a bank deposit account will only benefit from low rates of interest, but the money is safe. Even if a bank fails, the government guarantees the value of deposits up to £85,000. At the other extreme, if you’re seeking higher returns, you could invest in a high growth start-up company, but in these cases, there’s also a chance of losing capital.

People have different attitudes to risk. Some are naturally more adventurous or optimistic, and such glass half full people are more open to investment risk. Cautious people will have a different approach. 

But people’s attitude to risk also varies according to their circumstances. Somebody who has funds they can afford to lose may be inclined to take a punt on a higher risk investment, whereas the next person might be less inclined to risk their hard-earned nest egg.

It’s important, before you embark on any form of investment, that you understand your own attitude to risk and can choose assets accordingly.

 

Are there tax benefits to fixed term bonds?

Tax is an important consideration when making investments. Tax on the income or capital gain can make a significant dent in any returns, particularly if you are a higher-rate taxpayer. It follows, therefore, that if you can avoid tax, your returns will be so much greater.

In the UK, Individual Savings Accounts (ISAs) provide a highly tax-efficient way of investing. Through an ISA, you can invest up to £20,000 in the 2019/20 tax year without paying tax on the investments.

As far as fixed term bonds go, the three main types of ISA are Cash ISAs (fixed-rate and instant-access), Stocks and Shares ISAs and Innovative Finance ISAs (IFISAs). 

With a Cash ISA, your investment is in the form of cash and you receive interest on it, but that interest is tax free. It’s the same with a fixed-rate Cash ISA, except that here you commit to locking your money away for a fixed term - typically between one and five years - in return for a fixed-rate of interest.

With a Stocks and Shares ISA, your money is invested in company shares and in government and corporate bonds. The rates of return will typically be higher than those available in either of the two types of Cash ISA.

IFISAs were set up in response to the growing interest in the peer-to-peer (P2P) lending market and more investors taking advantage of the opportunities offered by high growth businesses raising funds on online platforms. They allow investors to use their annual ISA investment allowance to lend funds through the P2P lending market and buy other debt-based securities, while receiving the ISA tax advantages. 

IFISAs can include fixed term property bonds, which are issued by a company to fund property projects - including the purchase of land or properties, development finance and planning finance. 

 

What are the risks and returns of fixed term bonds held in an IFISA?

On the risk/return spectrum, IFISAs sit between Cash ISAs and Stocks and Shares ISAs. They’ll usually pay a better rate of return than a Cash ISA, while having a greater element of risk, but they can be more secure than a Stocks and Shares ISA, even if they tend to pay a lower rate of return. 

Also, property bonds held in an IFSA may be secured against the asset whose acquisition or development they were issued to fund. 

However, even if an IFISA is asset-backed, an economic downturn could affect returns and you may not get back the amount invested. In the event of default, the security held doesn't guarantee the return of your capital, and enforcing your security may take time and your returns may be delayed. IFISA investment isn’t covered by the Financial Services Compensation Scheme (FSCS).

 

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Your capital is at risk. MAVEN Bonds are asset-backed but an economic downturn could affect returns and you may not get back the amount invested. In the event of default the security held doesn't guarantee the return of your capital. Enforcing your security may take time and your returns may be delayed. Investment is not covered by the Financial Services Compensation Scheme (FSCS).