What is a fixed term bond?
Fixed term bonds have long formed an important element in any balanced investment portfolio and any investor should be aware of the different types available.
To put it technically, a bond is a fixed income instrument, representing a loan made by an investor to a borrower. It pays the investor interest at regular intervals at a target rate and, upon maturity, the original capital investment is also repaid. Essentially, it’s a type of IOU.
Bonds can be issued by businesses or governments as a means of meeting their funding needs. Depending on the issuer, a bond will carry varying levels of risk and any investor needs to be clear on the relationship between risk and reward and on their own appetite for risk.
People have different attitudes to risk. If you have money you can afford to lose, you might be more inclined to venture it in a high risk investment. People’s different risk profiles should lead them to take different investment strategies and will be an important factor in deciding the best fixed term bond for them.
It may be appropriate to hold a variety of assets with different risk profiles in a portfolio.
Diversifying with fixed term bonds
Diversification is an important investment principle and traditionally the diversified investment fund approach has been to go for a combination of bonds and equities to maximise the potential for a smooth return over the medium to long-term.
There should also be diversification within these asset classes. If you were to put all your money into one industry, or sector, or geographical region, and they do badly for any reason, then so will the value of your whole portfolio. But, in a carefully chosen and balanced range of investments, not only will your exposure to one type of asset be limited, but often falls in the value of one will be compensated by rises in another.
Tax benefits of fixed term bonds
Tax is another important investment consideration. It can take a big chunk out of any returns, but the reverse of that is that investing in a tax efficient way can turbo charge your investments.
This is the big advantage of ISAs or Individual Savings Accounts, introduced in 1999 to encourage saving and investment by offering generous tax breaks. Through an ISA, you can invest up to £20,000 a year without paying tax on the investments.
There are now seven types of ISA, the main two being Basic ISAs and IFISAs.
Basic ISAs can be divided into: Cash ISAs, Fixed Rate ISAs and Stocks & Shares ISAs.
As the name implies, with a Cash ISA your investment is in the form cash, on which you receive interest, as you would in a bank deposit account, but that interest is tax free. A Fixed Rate ISA is the same, except that you have to commit to locking your money away for a fixed term, typically between one and five years. In return for this commitment, you receive a fixed rate of interest, which is usually higher than with a simple Cash ISA.
With a Stocks & Shares ISA, your money is invested in company shares and in government and corporate bonds. Your investment can earn a return from dividend and interest payments, as well as any capital gains resulting from a rise in the value of the investments. The rates of return will typically be higher than those available in either of the two types of Cash ISA.
IFISAs and Fixed term bonds
IFISAs, or Innovative Finance ISAs, are the new kid on the block. They were set up in 2016 years ago in response to burgeoning interest in the peer to peer lending market. More investors were taking advantage of the opportunities offered by high growth businesses raising funds on online platforms, but any gains were taxable.
With the introduction of IFISAs, however, they could 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. They’re typically held for fixed period, of say to two to five years, and carry a fixed rate of interest, which can be paid to the holder regularly or rolled up to be paid over at maturity, along with the face value of the bond.
Risk vs Reward
In terms of risk versus reward, fixed term ISA bonds sit between Cash ISAs and Stocks and Shares ISAs. They will typically pay a better rate of return than a Cash ISA, but with a greater element of risk. However, they can be more secure than a Stocks & Shares ISA, even if they tend to pay a lower rate of return. Also fixed rate ISA 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 is not covered by the Financial Services Compensation Scheme (FSCS).
How do you decide which are the best fixed term bonds for you, having determined your attitude to risk? Here are some more considerations:
Undertake thorough research. There’s already a wide variety of types of provider and projected rates of return range from 3% a year to 15% and vary in terms of their risk. Does the provider have an online platform where you can view the progress of individual investments? Has it been established long and has it featured in the media? Does it have a track record in managing the kind of investment you’re considering?
All providers have a minimum investment allowance. Consider what’s affordable.
With fixed term ISA bonds, the investor can put together a diversified portfolio containing a number of bonds, paying at different intervals and with different maturity dates. Always ensure you don’t tie up all your capital so that there’s none available for an emergency.
Choose a property bond which is secured against the asset whose acquisition or development it was issued to fund.
The best fixed term bonds will differ from one individual to another, so always take advice on which is appropriate for you.