Fixed Interest Securities – The Facts
Fixed interest securities are one of the Bank of England’s main tools for controlling money supply in the economy following the credit crunch as the underlying asset traded in the quantative easing programme.
Fixed interest securities are not only tools for high finance – they are also accessible investments for most people.
What are fixed interest securities?
A fixed interest security is a bond that generates a fixed income over a given period.
In the simple terms, the bond is an IOU from the lending organisation, like a government, council, or company to the investor that guarantees a fixed return over an agreed term, and then repayment of the principal, or money owed.
In finance, fixed interest securities are packaged as different products, like government or corporate bonds.
Corporate and government bonds are traded on the stock market, so their value can rise and fall.
Bonds are rated by credit agencies like Moody’s or Standard and Poor’s. The highest rating is AAA.
Governments and companies have a credit score in the same way as individuals.
The rating looks at the risk involved in the bond issuer defaulting on the interest payments or loan.
Gilts have the triple-A rating, but corporate bonds can vary in risk. The idea is that by using a standard rating system, investors can compare the risk of different bonds without carrying out detailed due diligence on the issuer.
Generally, the lower the risk (higher the rating), the lower the interest paid on the bond.
Different types of fixed interest securities
Two of the most the most common forms of fixed interest securities in the UK are government ‘gilts’ and corporate bonds.
What are gilts?
A gilt is a bond issued by the Treasury and listed on the London Stock Exchange. The bond is called a ‘gilt’ – short for ‘gilt-edged security’ – as a reference to the low risk of the investment because the government has never failed to meet interest or principal payments on gilts.
What are corporate bonds?
Corporate bonds work in exactly the same way as gilts.
The idea is companies can raise cheap finance by issuing bonds. Instead of savers putting money on deposit with a bank that then lends the money to a business, the bond cuts out the middleman and lets the saver invest direct.
The rate of interest is fixed and designed to generate a steady income. Investors often look to gain at least as good an interest rate as paid by the bank, while the company looks to borrow money at a cheaper rate than going to the bank.
The Bank of England’s policy to put more cash back in to the economy by quantative easing is based on the strength of quality fixed interest securities.
Printing more money is against European Union rules, so instead the Bank buys gilts and corporate bonds.
The securities sit on the Bank’s balance sheet as an asset that the Bank sets off against transferring money in to the issuer’s bank account. The plan is that on a fixed date, the issuer has to buy the bonds back, cancelling out the money the Bank has injected in to the economy.