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How bonds and gilts work

Bonds and gilts are typically low risk fixed income investments which can take pride of place in any portfolio. Corporate bonds are issued by corporations and gilts are bonds are issued specifically by the British government to borrow money.

The safest corporate bonds are known as investment-grade – these are bonds rated BBB or above (by Standard & Poor's). Riskier bonds are known as junk bonds or high-yield bonds. And, as the name suggests, there high-yield bonds pay out a higher level of income to reward investors for taking on higher risk. You can also invest in government bonds. UK government bonds, known as gilts, are regarded as being risk-free investments, safer even than AA-rated corporate bonds. On the other hand, bonds issued by governments in emerging markets can be pretty risky.

Bonds have both an income value and a capital value. They pay out interest, known as a coupon. The coupon is the yield at issuance. However, bond yields vary in relation to interest rates. If interest rates fall, bond prices will rise and bond yields will fall. If interest rates rise, bond prices will fall ad bond yields will rise. Hence, the important figure to look at is the running yield.

The intital price of a bond is call par – if you invest in a bond at issuance and hold it to redemption, you should receive its par value back. However, because a bond's price can vary during is life, you would suffer a loss on maturity if you bought above par (or vice versa). This is reflected in the redemption yield.

Losses or gains depend on how long a bond has to maturity (known as duration). Each percentage point change in interest rates is magnified by the number of years to maturity. For example, a 1 per cent rise in interest rates would lead to a 5 per cent call in the value of a bond with five years left to maturity.

But bonds can act as good portfolio diversifies for investors because they tend to perform differently from shares. This is known as having a low correlation. For example, when stock markets fell between 2000 and 2002, central banks cut interest rates to stimulate economic growth. In turn, bond investors enjoyed rising capital values, offsetting the losses on their equity holdings.

Bonds offer an income advantage over shares, though, when held in an individual savings account (Isa) because interest is paid tax-free, whereas dividends on shares are paid out net of tax, which can no longer be reclaimed in an Isa.

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