I'm confused about 'bonds'! Are they savings or investments?
In the movies, Bond means only one thing – martinis, gadgets and car chases. In finance, the word ‘bond’ means many things.
Its use in real life – as in, ‘My word is my bond’ - suggests an agreement, an obligation or a pledge, a connection even.
And that is roughly still what it means when used in finance: a sort of IOU between a lender and a borrower. The lender – the holder of the bond - is a saver or investor, which could be a fund or an individual. The borrower is typically a government, a corporation or a smaller business.
But it can get complicated. Here we pick apart the different kinds of bond.
These are issued to raise money for public spending – it is essentially how governments borrow money. The government promises to pay the buyer small cash payments – usually twice a year until the bond matures, when the buyer also gets back the money loaned to the government. Bonds can have a lifetime of anything from three years to decades.
Individuals rarely buy them any more but many of us who have company pensions will have some exposure to government bonds as they represent one of the main asset classes that funds and pensions schemes invest in – a low risk, low return asset to counter-balance riskier investments like equities.
If you see the word bond or ‘fixed-income’ in a fund name it is likely to be focused – but maybe not exclusively - on government or corporate bonds, or both.
UK bonds are also referred to as gilts, and in the US they are sometimes called Treasury bills. Bonds from the world’s leading economies are called ‘investment grade’ and are seen as ultra-safe or ‘gilt-edged’ investments – but they pay poorer returns, because there is so little risk for the borrower.
These work in almost exactly the same way as Government bonds but it is a company doing the borrowing – and the quality or safety of the bond will depend on the financial strength of the company issuing it.
The safest corporate bonds will pay the lowest returns and the riskier ones, the higher returns.
Again, individuals rarely buy corporate bonds – but many have exposure through funds they hold or their company pensions.
Corporate bonds are generally seen as less risky than shares, but crucially they are not backed by the Financial Services Compensation Scheme - the guarantee that protects savings products.
We are still in lean times for savers. The best easy-access savings accounts pay 1.5% - well below the rate of inflation currently at 1.9%, which means the value of your cash is being eroded in real world terms.
To get the best savings rate on the market - a rather underwhelming 2.5% - you have to lock your cash away for five years in a fixed-rate savings account. Hardly makes one want to scrimp and save, does it.
These fixed rate savings were in the past often referred to as ‘bonds’, as you were agreeing to tie up your money.
And NS&I for one still calls one of its savings products bonds – whether it’s Premium Bonds that are a sort of lottery, or its guaranteed income or growth bonds, which act just like fixed-rate savings.
So what is the difference between these and other sorts of ‘bonds’?
Under the FCSC, you can hold £85,000 in cash savings with each UK-regulated bank and know that you will get it back from the government if it gets into trouble. That's enough for most of us, but if you have more than that to put away you either spread it across several banks or look at NS&I where the guarantee limits are much higher.
These are a new(ish) sort of product that has grown in popularity in the decade since interest rates were cut to rock bottom. They are aimed squarely at the small investor and savers, often through advertising.
They are a sort of corporate bond that offer eye-catching rates of return, well above savings rates.
They are generally offered over a period up to five years and on their 'maturity' date, the investor gets back the original investment in full. Assuming nothing has gone terribly wrong.
The company could fail, or fail to make the money it needs to finance the bond and its repayment. In other words your capital is at risk and you are not FSCS covered. It's investing.
The vast majority of retail bonds have honoured their promises but they vary in riskiness, and a few have collapsed. Most notably, the London Capital & Finance bond, which has recently been in the news after collapsing, owing £236m.
These are a kind of retail bond that are seen as more risky because you cannot sell them before the maturity date. You can trade retail bonds - although they do fluctuate in price, like shares, so if you have to sell it might be at a loss.
Mini-bonds often pay even higher rates of return to compensate for the higher risk and they are not as tightly regulated. It doesn't mean they are dodgy, it just means you have to go in with your eyes open and do your homework.