Steer Clear Of Stock Market Storms

If the stock market is too racy and cash is too dull, should you consider bonds instead?

The thrills and spills of the stock market have always led cautious investors into the path of more stable assets. The risk-averse among us have deserted shares in our droves for the relative safety of bonds. Bonds certainly don't suffer the same rocky ride we have come to expect from shares but are they a good investment choice?

Before I answer that, we need to understand the basics because there's more to bonds than meets the eye. They generally come in two main types: gilts and corporate bonds. In this article I'm going to focus on gilts. I'll look at corporate bonds in more depth in a later article.

What is a Gilt?

A gilt is simply a way for the government to raise money. Yes, believe it or not our taxes don't stretch far enough! A gilt is a loan to the government and in return you, the lender, earn a fixed rate of interest - known as the coupon - until the gilt matures on a fixed future redemption date. If the gilt is bought directly from the government, you'll receive back the nominal value on redemption which is set at £100 per gilt. Gilts are low risk because the chance of the government defaulting on these loans is negligible. If the government goes bust, heaven help us all!

The actual price you'll pay for the gilt, along with its coupon and redemption date, will be set by the UK Debt Management Office (an agency of HM Treasury) on issue. The coupon you'll earn is always expressed as a percentage of a £100 nominal holding and divided into two equal six-monthly payments. In other words, a gilt with a coupon of say, 5% will give you £5 each year in two £2.50 installments until the redemption date. If you buy a gilt for more than £100 - what's known as above par value - you'll lose money if you hold it until redemption because you will only receive £100 back. (You will, of course, receive your coupon too.) But equally, if you buy at less than £100 - that is, below par value - you'll make a profit on redemption.

Gilts can be sold before their redemption date but the selling price will no longer be guaranteed at £100. Trading Gilts Gilts can also be traded through a secondary market after they have been issued. You can diversify your investment by choosing gilts with different purchase prices, coupon rates and redemption dates. After issue the gilt price will be influenced mainly by expectations for long-term interest rates, inflation and economic growth. When interest rates fall, gilt prices rise and vice versa.

Gilts appeal to investors when interest rates are cut because the fixed income they pay out is more attractive and this, in turn, pushes up prices. What's more, if you decide to sell the gilt before redemption you may make a capital gain (or loss) depending on the price you can sell it at. So it's possible, in the right circumstances, to make a profit even if you sell a gilt that was originally bought above par value.

Index-linked Gilts

This type of gilt is protected against the effects of inflation (rising prices) which can seriously erode its value if held for the long-term. They work in exactly the same way as conventional gilts except the interest payments and value at redemption keep pace with inflation. The coupon rate will be lower on index-linked gilts to start with. If you're trying to decide between the two you'll need to work out which you think is better value. Roughly speaking, inflation - as measured by the retail prices index (RPI) - would need to be 2.5% for returns from index-linked gilts to be broadly equivalent to conventional gilts held to redemption. If you think inflation over the term you want to invest is likely to be higher than that, then index-linked gilts could be the way to go.  

Tax

Thankfully this is pretty simple. Interest earned is payable gross but it is subject to income tax and must be declared on your tax return. But any gain made on sale or redemption is exempt from Capital Gains Tax (CGT). Gilts held within an ISA fund are free from both income tax and CGT and don't need to be declared. How do you buy Gilts? Gilts can be bought at auction and sold through the Debt Management Office. They can also be bought on the secondary market via banks and stockbrokers. Charges will apply to gilt purchases. Alternatively, you can invest in a gilt fund, instead of buying gilts directly yourself. Your investment will be run by a fund manager who will be responsible for trading gilts to provide the best possible return for you. There is currently over £22.3 billion invested in funds like these and billions more in individual gilt issues.

Should You Buy Gilts?

You could say gilts are a halfway house between cash savings and shares from a risk perspective.If you're looking for an income, then gilts may be a good bet because the return is fixed. You'll always know exactly what you're getting each year plus you'll have the security of lending to the government. But before you take the plunge think about interest rates over the long-term. If you're locked into a fixed income from a gilt of say, 6% you may be quite happy now. But what if interest rates rise to 7% or 8% in the future? Will you be so happy then? This is a difficult call since gilts can be very long-term investments. After all, a few gilts issued back in 2005 are set to run for a whopping 50 years!

More: How To Shelter From Sliding Shares.