Cash into corporate bonds a good move?
|Investment | Fixed Interest
Asked by brianc, submitted
19 December 2009.
Why are Government Gilts and Corporate Bonds always linked together when they are so different?
To avoid the bank low interest rates I have transferred my cash ISAs into Corporate Bond Fund ISAs. I realise these are not as safe as Gilts, but have I made the correct decision? I am 66 years old.
Answered by Justin on 22 December 2009
Gilts and corporate bonds are fundamentally very similar; they’re both IOUs that pay a fixed rate of interest. This is why they’re collectively called ‘fixed interest’. The three factors that most influence price and the interest paid are inflation, interest rates and the financial health of the government or company that issued the gilt or bond.
What differs in practice is how sensitive they are to these three factors.
Gilts (also called ‘treasuries’ or ‘sovereign debt’) are issued by governments and usually seen as a very safe bet in developed economies such as ours (most people trust the Government to repay an IOU). Because gilts are perceived to be the safest type of fixed interest they tend to pay lower rates of interest (called ‘coupon’) than corporate bonds which are issued by companies.
Companies are, to varying degrees, seen as being more likely to default on an IOU (i.e. fail to repay interest and/or the sum loaned) than a government, so they must usually pay a higher rate of interest to tempt investors into taking the perceived additional risk. The extra interest paid over gilts is called the ‘risk premium’. The more investors think a company is likely to default the greater the risk premium they’ll demand.
Interest rates (e.g. the Bank of England Base Rate) matter as the higher they are the more interest a government or company will have to pay on its IOU to compete with cash, i.e. money in a savings account.
Inflation is fixed interest’s enemy because it means the IOU will buy less when it’s repaid in future (called ‘redemption’) than today.
Now, a really important point to understand is that although I’ve talked about gilts being safe, they could still lose you money if you buy or sell before redemption. Let’s say a gilt (or bond) is issued at 100p paying 4% for 20 years. If you hold until redemption you‘ll receive 4p each year and 100p at redemption for every gilt you own. But suppose you decide to sell after a few years and interest rates have risen to 8%. No-one would want to buy your gilt for 100p as they’ll only earn 4p, whereas they could get 8p interest by putting their money in a savings account. In theory the gilt price might have to fall to 50p to attract a buyer (as the 4p income from your gilt divided by a 50p purchase price equals 8% income, comparable to the savings account). Your ‘safe’ gilt investment has just lost you half your money – a bit extreme but it highlights the point.
Likewise, rising inflation tends to reduce gilt and bond prices, as does concern that an issuer might default.
In general the lower the coupon paid and/or the longer the period until redemption the more sensitive a gilt or corporate bond price will be to interest rate and inflationary movements (and of course vice versa). When there’s a greater perceived risk of default (e.g. ‘high yield’ bonds) then price is usually more influenced by the issuer’s financial health than interest rates and inflation.
Was switching your savings into corporate bond ISAs a good move? If you did so at the beginning of this year you should be laughing. Corporate bonds have enjoyed an exceptionally strong year thanks to low inflation, low interest rates and lower perceived default risk all pushing up prices.
However, if you’re expecting 2009 type returns in future then I’m afraid you’ll probably be disappointed. Inflation and interest rates look more likely to rise than fall over the next few years, which could push down prices. This might be countered by further falls in the perceived risk of default due to improving optimism, but interest rates and inflation will probably be the dominant factors unless you’ve purchased high yield bond funds.
You can read more about fixed interest investing on our fixed interest page.
Provided you still have savings to cover any shorter term financial needs, then leaving the corporate bond funds invested for 5-10 years or more seems sensible as it’ll likely leave you better off versus a savings account. If they’re your only investment you might consider diversifying a little so that you don’t have all your eggs in one basket.
On a wider point, the downside of moving cash ISAs into shares ISAs (which includes corporate bonds) is that it’s a one-way move. You can’t subsequently switch back into a cash ISA. This may not be an issue for you, but I mention it as a reminder to other readers considering such a move.