Managing my financial journey
Managing my financial journey

Start this free course now. Just create an account and sign in. Enrol and complete the course for a free statement of participation or digital badge if available.

3.1.6 Bonds – currently offering low yields for investors

In personal finance, the terms ‘savings’ and ‘investments’ have different meanings. Savings accounts refer to any form of deposit account that pays interest on top of the amount deposited. The amount deposited is not at risk unless the institution defaults. Investments also allow interest or dividends to be paid but, crucially, the investment itself can fall or rise in value. Financial investments are those products with the warning in the small print that the value of your investment can go down as well as up.

Financial investments, which for simplicity we will call ‘investments’, include shares and bonds and investment funds that hold these types of assets. The amount invested – the ‘principal’ or ‘capital’ – is usually at risk, as well as the rate of return on the investment.

This means that it is not income alone that is relevant (as the rate of interest is on savings products) but the total return, which may be made up partly of income and partly of the change in the value of the capital. If the price of the investment goes up, a capital gain will be made, but if the price goes down, a capital loss is made. Newspapers often print cases of investors who have lost money on investment schemes.

With increased regulation of financial intermediaries and other financial firms, including the actual providers of savings and investment products and their salespeople, and the requirement to explain fully the characteristics of the financial products they sell, mis-selling of financial products should, in theory, be unlikely. But it still happens.

A bond generally represents a promise to pay a regular rate of interest over a fixed period, from 1 to 50 years, plus the promise to repay the nominal value (also known as the face value) of the bond (say, £100) on the maturity date. The interest rate is normally fixed, for instance, at 5 per cent or 10 per cent of the nominal value each year.

The nominal value is the amount on which the interest is calculated and can be divided into small amounts for sale, usually £1000 or less. For example, an investor could buy £100 nominal of a ‘5-year 5 per cent bond’. This will pay 5 per cent a year for 5 years on £100 nominal – that is, £5 a year. The interest may be paid quarterly, semi-annually or annually, depending on the type of bond bought. At the end of the 5-year period, an investor would receive £100 in repayment of nominal (or ‘face’) value.

Bonds tend to be less risky than shares because they have a promised interest rate and because company bonds rank in front of company shares in the event of a company being liquidated. Although less risky than shares, bonds are riskier than savings accounts. This is because with savings products typically the amount of capital you receive back is fixed – if you deposit £100, you get £100 back.

With a bond, the amount paid back on maturity is also fixed (but may be more or less than the amount paid for the bond). However, if the bond is sold before maturity, then more or less than the promised nominal amount may be paid. Whether it is more or less will depend on movements in the level of interest rates after the bond has been issued. If interest rates fall, the market value of an earlier issued fixed-rate bond will rise, since it offers investors an interest rate higher than that currently being offered on newly issued bonds. The reverse applies if interest rates rise.

In the ultra-low interest rate environment following the financial crisis, the yields on bonds have been at historical lows, whilst the market value of bonds issued before the crisis have soared as they offer higher interest rates than those on bonds issued in recent years.

An additional risk of bonds is if the issuer of a bond defaults. UK government bonds, known as gilts, are seen as safer than bank and building society accounts, as the government is even less likely than a bank or building society to default. Bonds can be bought through stockbrokers or, in the case of gilts, through a special purchase and sale service organised by the Debt Management Office, the government department responsible for issuing government debt. As gilts are safe to invest in, their returns are normally the lowest you can get on sterling-denominated bonds. In November 2017, the return for investing in a 51-year gilt was 1.69 per cent per annum.

One problem with bonds is that not everyone means the same thing when they talk of a ‘bond’. The kinds of bond we have described are company or government bonds with a fixed interest rate and a fixed repayment date. But the term ‘bond’ has sometimes been taken in vain. Financial intermediaries have sold bonds that were in effect shares by another name. Similarly, long-term savings products may not only be bank accounts promising interest, but also linked to company bonds or shares. There is no regulation in the UK on terminology, and consequently it is important to read the small print of any product.

Some National Savings & Investment products use the name ‘bond’ – for example, Premium Bonds and Income Bonds – but are types of deposit. A range of products, some that are deposits and others more risky investments, used to be called Guaranteed Equity Bonds. Although they have since been reclassified as ‘structured products’, they still individually go by names such as Capital Bond, Stockmarket Linked Bond and Double Asset Bond. Therefore, in reality, the term ‘bond’ is applied to products that are very different, and not just company or government bonds. To get round this confusion, you will also see true bonds referred to as ‘fixed-interest’ investments.

An important product that does not fit within the bonds category that we have described is the Premium Bond. Premium Bonds, owned by 22 million investors in the UK in 2013, are a lottery-based form of savings account backed by the UK government. A lottery is held every month and the equivalent of 1.3 per cent p.a. (in 2017) on all the Premium Bonds is paid out in tax-free prizes.

Take your learning further

Making the decision to study can be a big step, which is why you'll want a trusted University. The Open University has 50 years’ experience delivering flexible learning and 170,000 students are studying with us right now. Take a look at all Open University courses.

If you are new to University-level study, we offer two introductory routes to our qualifications. You could either choose to start with an Access module, or a module which allows you to count your previous learning towards an Open University qualification. Read our guide on Where to take your learning next for more information.

Not ready for formal University study? Then browse over 1000 free courses on OpenLearn and sign up to our newsletter to hear about new free courses as they are released.

Every year, thousands of students decide to study with The Open University. With over 120 qualifications, we’ve got the right course for you.

Request an Open University prospectus371