Learning the Facts About Fixed Interest Securities
In this article, we look at how fixed-interest securities work and the roles that they play for both individual investors and the economy. This is useful reading if you’re studying for the CII’s R02, J10 or AF4 exams.
This article is correct as at 19 January 2023.
What are fixed-interest securities?
A fixed-interest security is a type of bond that generates a fixed income over a given period.
In simple terms, the bond is an I.O.U. from the borrowing institution, e.g. a government, local authority, or company, to the lender (the investor), that guarantees a fixed return over an agreed term and repayment of the original loan.
For both individual and institutional investors, fixed-interest securities can be packaged as different products, like government or corporate bond funds as part of a unit trust or OEIC offering. They may also be wrapped in ISAs or pensions for tax efficiency. Individual government and corporate bonds are traded on the stock market, so once issued their values can rise and fall.
Different Types of Fixed-Interest Securities
Two of 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 HM Treasury and listed on the London Stock Exchange. The bond is called a ‘gilt’ – short for ‘gilt-edged security’. The government has never failed to meet interest or loan repayments on gilts and so they are deemed low risk.
What are corporate bonds?
Corporate bonds work in much the same way as gilts but are issued by companies looking for a cheaper way to raise finance.
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 lend directly.
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 banks and building societies, while the company looks to borrow money at a cheaper rate than going to a more mainstream lender.Looking at how fixed-interest securities work and the roles that they play for both individual investors and the economy - useful for #CII #R02 exam revision Click To Tweet
Assessing the Risk
Bonds are rated by credit agencies like Moody’s or Standard and Poor’s. A bond’s rating is determined by the agency’s assessment of the likelihood of the bond issuer defaulting on the interest payments and/or the loan repayment.
UK government bonds have a double-A rating, but corporate bonds can vary in risk. 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.
Quantitative easing (QE) involves the Bank of England creating digital money and using it to buy government (usually) and corporate (sometimes) debt in the form of bonds. The aim is simple; by creating ‘new money’ the Bank hopes to boost spending and investment within the economy.
The securities sit on the Bank’s balance sheet as an asset that the Bank sets off against transferring money into 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 into the economy.
In 2009, following the global recession that took hold in late 2008, the UK government started a programme of QE and bought back government bonds – this led to an increase in bond prices which lowered the interest rate (or yield) on those bonds. Because rates on government bonds tend to impact other interest rates in the economy, taking out loans such as mortgages and business loans became cheaper, encouraging households to spend.
Following the programme of QE announced in 2020 to help the economy bounce back after Covid-19, the Bank of England’s purchases of government bonds totalled £895 billion. In November 2022, the Bank began to sell the bonds they had previously purchased. This is known as quantitative tightening and its aim, together with increasing the Bank base rate, is to get inflation back under control.
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