Investing in Bonds

You may have read that as you near retirement you should increasingly be moving your investments from equities into bonds. The reason for this advise is that although bonds generally offer less opportunity for capital growth, they tend to be lower risk as they are less exposed to stock market volatility and also have the advantage of producing a regular guaranteed income. Although normally recommended as sensible, a particular problem owing to the recent downturn in the stock market is that you could make a loss by selling some of your shares now, whereas possibly if you wait, they might recover. A bigger problem is that there are different types of bonds, with varying degrees of risk, which it is important you should understand.

 The three main types are: government bonds  called gilt-edged securities or gilts  corporate bonds and investment bonds. Gilts are the least risky as they are secured by the government, which guarantees both the interest payable and the return of your capital in full if you hold the stocks until their maturity. Corporate bonds are fairly similar except that, as opposed to loaning your money to the government, you are lending it to a large company or taking out a debenture. The risk is higher because, although you would normally only be recommended to buy a corporate bond from a highly rated company, there is always the possibility that the company could fail and might not be able to make the payments promised. In general, the higher the guaranteed interest payments, the less totally secure the company in question.

 Although gilts and corporate bonds are normally recommended for cautious investors, investment bonds are different in that they offer potentially much higher rewards but also carry a much higher risk. Because even gilts can be influenced by timing and other factors, if you are thinking of buying bonds, expert advice is very strongly recommended.

 Investment bonds

Definition: This is the method of investing a lump sum with an insurance company in the hope of receiving a much larger sum back at a specific date  normally a few years later. All bonds offer life assurance cover as part of the deal. A particular feature of some bonds is that the managers have wide discretion to invest your money in almost any type of security. Although bonds can achieve significant capital appreciation, you can also lose a high percentage of your investment. An exception is guaranteed equity bonds, which, although linked to the performance of the FTSE 100 or other stock market index, will protect your capital if shares fall. However, although your capital should be returned in full at the end of the fixed term (usually five years), a point not always appreciated is that, should markets fall, far from making any return on your investment, you will have lost money in real terms: first, because your capital will have fallen in value, once inflation is taken into account; second, because you will have lost out on any interest that your money could have earned had it been on deposit.

 All bond proceeds are free of basic-rate tax but higher-rate tax is payable. However, the higher-rate taxpayer can withdraw up to 5 per cent of his/her initial investment each year and defer the higher-rate tax liability for 20 years or until the bond is cashed in full  whichever is earlier. Although there is no capital gains tax on redemption of a bond (or on switching between funds), some corporation tax may be payable by the fund itself, which could affect its investment performance. Companies normally charge a front-end fee of around 5 per cent plus a small annual management fee, usually not related to performance.