What are fixed-interest investments?
Last week in our basket full of smashed eggs series, we looked at equities, which allow you to own a small piece of a company. We talked about how they are more volatile than many other investments and can go up as well as down.
This week, we’re looking at another type of egg in the basket: Fixed-interest investments, otherwise known as:
What is the history of fixed-interest investments?
Fixed-interest investments have a long history. The premise is simple; the investor effectively buys ‘debt’ from a government or company, and over a period of time (the term) the company will pay back that debt in full, alongside some interest added on top to say thanks for lending them the money.
Just like with equities, the lowlands of Northern Europe was where this story began. History states that the first government bonds were issued in Netherlands (or Amsterdam, at the time) all the way back in 1517.
The first official government bond was issued a bit closer to home, here in lil’ old Blighty. The Bank of England issued the first government bond in 1694 in order to raise money to fund a war against the French. They would issue a bond with the promise to pay back the money at the end of a period, with interest added on top.
Since then, companies have also used bonds to raise money in this way. Guess where the first corporate bond was issued? Yep, the Netherlands. The Dutch East India Company (VOC) issued the first corporate bonds to the public back in the 17th Century.
Since then, almost every government offers bonds of some sort. The market for corporate bonds is sitting at around $5-6 TRILLION *gasps*.
Why are they important?
Rather than paying out investors from company profits (which is what equities do), corporate and government bonds pay out interest. With corporate bonds, the investor is lending the company some money, whereas with equities, the investor is buying an ownership share of the company.
The important thing to note is that with corporate bonds, the original investment amount is only at risk if the company collapses. If this happens, the company must pay its bondholders and creditors first. This means that the investor’s money is potentially safer than with equities, where nothing is guaranteed to be returned when they sell the shares back.
Government bonds (or Gilts) are seen as much less risky than corporate bonds and even more so than equities. They are issued by the Treasury and are therefore almost 100% secure, as the only way that the debt wouldn’t be repaid is if the government itself fails.
In return for this low level of risk, the returns aren’t as high as those for higher-risk investments such as equities.
Corporate bonds are ‘graded’ by their creditworthiness. The highest quality bonds are called Triple-A (AAA) Bonds. These are the safest but give the lowest amount of interest. The least creditworthy bonds are called ‘junk’ bonds. With this type of bond, the company is usually struggling financially, and therefore the investor is at higher risk of default. As a result, the company will pay more in interest to offset the risk taken by the investor.
What is their future?
At the time of writing, the return on government bonds (gilt yields) are very low. We would expect the Treasury to need a high level of funding from the public in order to pay for the hole left by COVID-19. This could mean gilts may become more attractive.
It may be easy to panic given the past few months and see these as a lower-risk strategy rather than equities. We’re ignoring the noise and staying true to our word. This means putting our trust in the markets and believing that the upward trend will return once more.
With investing your capital is at risk and your money can go up and down at all times. You may get back less than you invest.