Stocks and bonds/gilts

Stocks and bonds

It is firstly important to note that stocks and bonds are different. A bond is a loan in which you the investor loans money to the issuer of the bond. The issuer can be a company, local authority or government. In return for lending the issuer their money, the investor receives interest from the bond (much like a bank receives interest for lending you a mortgage).

A bond is set a maturity date at which the issuer pays back the initial sum of the bond. The dates can vary from

• short term [bills] (up to 1 year)
• medium term [notes] (1-10 years)
• long term [bonds] (10 years +)

Bonds are considered a safer investment than stocks as the investor receives the same sum he/she invested back at the maturity date. This is not the case with stocks as the stock price rises and falls meaning the investor could receive a lot more or a lot less back from their initial investment, hence the increase risk.

Note: Bond prices do rise and fall as they are traded on the stock market, however the rise and fall in their price is nothing an investor needs to worry about as they are guaranteed their initial investment back.

Gilts

Gilts is a word used for bonds issued by the UK, Ireland and South African governments. the government issue different types of gilts and bonds, as shown below.

Types of bonds

• Fixed rate bonds – the interest remains the same through the duration of the bond.
• Floating rate notes – are when a bonds interest rates vary are linked to an index such as LIBOR or the US federal reserve rate. Floating rate notes are designed to guard against interest rates.
• Zero interest bonds – the investor does not receive any interest but gains a discount from the face value price and is paid the full face value price back at maturity.
• Inflation bonds – the bonds interest rate is linked to the national inflation rate and are designed to cut out the inflation risk of an investment.
• Serial bonds – A bond that matures over a intermittent period. E.g. a $10,000 4 year bond would mature by $2,500 each year.
• Lottery bonds (which is what premium bonds are in the UK) – interest is paid the same as a fixed rate bond but the issuer will randomly select bonds to, in effect, win cash prizes.
• Bearer bonds – is a certificate issued without a named person as the holder. The person who has the certificate redeem it for the value of the bond. They can be traded like cash but are risky because they could get lost or stolen. Bearer bonds were stopped by companies in the 60’s and by the US treasury in 1982.
• War bond – Are issued by countries at war to raise extra cash to fund their forces.

The risk

The biggest risk when investing in bonds is if you invest in company bonds and the company goes bust, you will not receive back your initial investment. Also if the company you are investing in struggles they may not pay you the interest on your bond.

Government bonds (gilts) are deemed less risky as a government is expected to pay back the full amount. However the interest received by the investor is often lower due to the perception of lower risk.