An introduction to fixed term bonds

Posted Aug 21, 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, or amount lent, 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 of 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 that is the way to achieve the all important element of diversification. Diversifying means not putting all your eggs on 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, five to 12 years; or even 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. Age also matters. Somebody approaching retirement will tend more to want to protect the value of their savings, while a younger person may lean towards a higher risk/higher growth strategy.

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 also an important consideration when making investments, including fixed term bonds. Tax on the income or capital gain can make a significant dent in any returns, particularly if you are a higher rate tax payer. 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 a year without paying tax on the investments.

IFISAs were set up in response to the growing interest in the peer to peer 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 some, or all, of their annual ISA investment allowance to lend funds through the peer to peer lending market and buy other debt based securities, getting the ISA tax advantages. 

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

 

Risks and rewards of Fixed term bonds using an IFISA to invest

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 & Shares ISA, even if they tend to pay a lower rate of return. Also property bonds held in an IFISA 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. Enforcing your security may take time and your returns may be delayed. Investment isn’t covered by the Financial Services Compensation Scheme (FSCS).