Fixed Interest

The fixed amount of interest you receive is known as the 'coupon'. In practice, most fixed interest investments quote their income as a 'yield'. The simplest version is the 'income' yield, which is the annual coupon (i.e. interest) divided by the price of the gilt or bond. If a bond is priced at 100p and the coupon is 6p then the income yield is 6%. This makes it easy to compare the income return to other investments and savings accounts.

The amount of coupon a government or company pays mainly depends on interest rates and the likelihood they'll be able to pay coupons and repay your money at redemption.

If you can get 5% interest in an easy access savings account then a government or company will have to offer you more than this to encourage you to tie up your money for many years. Furthermore, if there's some doubt over their ability to pay your coupons and/or repay your money at redemption (i.e. they might 'default') they'll have to offer a lot more interest to compensate for the potential risk. This is known as the 'risk premium'.

If you buy a 30 year 5% bond at issue for 100p then you'll get 100p back at redemption. But what happens to the price meanwhile? Again, this depends mainly on interest rates and perceived risk that a government or company might default.

Suppose interest rates shoot up to 10%. Your bond pays 5p income whereas putting £1 in the bank would pay you 10p income. Clearly, the bond is now very unattractive to new investors, the price of the bond would need to fall to 50p for a new investor to receive 10p income for each £1 invested. Bond prices tend to move in the opposite direction to interest rates.

Suppose instead that the company who issued the bond is struggling financially, casting some doubt over their ability to pay the coupon. Investors will demand a high risk premium to compensate for the possibility the company will default. If they believe a yield of 15% is sufficient compensation, this will push the price of the bond down to 33p.

While these examples are a bit extreme, they do highlight how the price of fixed interest investments can vary between issue and redemption. While a risk, it can also create good investment opportunities.

Knowing this we can now use a more complete yield measurement, called 'redemption yield'. This takes account of any difference between the price of the bond now and the redemption value, i.e. it includes any profit or loss you'll make on the bond's value if held until redemption.

Use our Redemption Yield Calculator to estimate the redemption yield on a particular gilt or bond.

Bond prices are also sensitive to inflation. High inflation means an investor's initial stake will be worth far less in real terms when it's returned at redemption, pushing down the bond price.

A gilt or bond's sensitivity to interest rate and inflation movements tends to depend on the length of time until redemption. The longer the period the greater the impact is likely to be.

Gilts are bonds issued by the Government and traded on the London Stock Exchange. The coupon is paid in two equal instalments per year and the gilt has a specific redemption date. Gilts are issued at a 'nominal' price of 100p.

Gilts include the coupon and redemption date in their name. For example, a Treasury 5% 7 March 2018 is a gilt that pays an annual coupon of 5p (two 2.5p payments) and will redeem on 7 March 2018.

Because gilts are backed by the British Government they are viewed as being very secure, hence their yields are normally lower than corporate bonds.

Differ from conventional gilts because both the coupon and redemption value are adjusted in line with inflation (measured by the Retail Price Index) since the gilt was issued.

So, a Treasury 2% Index-Linked 26 January 2035 gilt will pay an annual coupon of two 1p instalments, each multiplied by inflation since issue and will redeem 100p (again multiplied by inflation since issue) on 26 January 2035. For example, if RPI has risen by 40% when a coupon is due, you'd receive 1.4p. If RPI has risen 130% by redemption your initial 100p investment would be returned as 230p.

RPI is measured on an eight month lag for index-linked gilts issued before September 2005 and a three month lag thereafter.

Index-linked gilts are attractive compared to conventional gilts during periods of high inflation, but less so during periods of low inflation or deflation.

These are bonds issued by large, financially stable, companies. The likelihood is that you'll receive all your coupons and return of your original loan at redemption.

Most companies pay the coupon in two equal instalments each year, but it can be more or less frequent.

Yields tend be higher than gilts because companies are not viewed as being as safe as the government. The extent of this difference, i.e. the risk premium, is called the 'investment grade spread'. The higher the spread, the weaker companies (hence the economy) are perceived to be.

These bonds, sometimes called 'junk', are issued by companies whose credit worthiness is less certain. You can be less sure about receiving all your coupons and return of your original loan at redemption compared to an investment grade bond.

As a result of the higher potential risks, high yield bonds have to pay higher yields than investment grade bonds to attract investors.

High yield corporate bonds also tend to be affected by stock market movements more than investment grade. Falling markets usually increase worries over the ability of weaker companies to pay the coupon (and eventually return the initial loan) on their bonds. In other words, high yield bonds normally have a higher correlation to stock markets than investment grade bonds.

Permanent Interest Bearing Shares (PIBS) are effectively bonds issued by building societies. They are listed on the London Stock Exchange and normally have no redemption date, although some have a 'call' date which gives the building society the option to redeem the PIB on that date should they wish.

The coupon is usually paid in two equal instalments each year.

Although PIBs have historically been viewed as quite safe, the 2008 banking crisis clearly highlighted the risks. If a building society becomes insolvent then PIB holders sit at the bottom of the pile in terms of getting their money back (although above shareholders if the society had 'demutualised').

As their name suggests, zero coupon bonds pay no coupon throughout their life. They're instead sold at a 'discounted price' which rises over time to a final redemption price, i.e. the coupons are effectively rolled-up within the bond.

Zero coupon bonds tend to be more sensitive to interest rate movements than conventional bonds.