Six things you should know about bonds

With inflation so high, it's difficult to protect the value of your money. One solution is to buy inflation-linked corporate bonds. But before you do, Tim Bennett explains six things you need to know.

If you're trying to protect your money from the ravages of inflation, you're probably feeling a bit desperate by now. With British inflation at 5.2% (according to the retail price index, or RPI), a 40% taxpayer needs to get 8.7% just to stand still. No savings account will pay you that kind of rate, and the government-backed National Savings & Investment bank has just withdrawn its RPI-linked savings certificates. So where can you go?

If you're willing to risk your capital, but aren't keen to invest in stocks, you might be tempted by some recent corporate bond issues aimed at the retail investor. Utilities giant National Grid (NG) has just launched its first inflation-linked bond, joining a growing queue of issuers that includes Tesco, HSBC, Caxton FX and Hotel Chocolat. There's plenty to like about these bonds, but if you are new to the sector, here are six things you need to understand before you take the plunge.

1. Coupons are not dividends

Shareholders are used to receiving a dividend determined by a firm's directors. Bondholders usually get a fixed coupon, or interest payment in two semi-annual instalments. So, for example, Tesco's 5.5% bond pays the holder exactly £5.50 per £100 nominal value. NG, on the other hand, is offering the change in the RPI plus 1.25% annually as a coupon. So if the RPI rises 10% that's 1.375% (1.25% x 1.1). Provided a bond issuer doesn't go bust you're guaranteed to get a coupon. That's not true of shares in a bad year for profits dividends can be cut.

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2. Bonds redeem, shares don't

When you buy a share, you are buying a stake in a company. Bonds, on the other hand, are in effect IOUs so at some point the company has to pay them back. This is the redemption date'. But what you get back can vary, so always check the small print. For example, a standard bond such as Tesco's redeems at £100, or par'. However, with NG you get your £100 plus any change in the RPI over its life (with a minimum payback of £100 if the RPI falls).

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One consequence of this is that, when you look up a bond, you'll usually see two yields quoted. The flat yield is just the annual coupon as a percentage of the current price. So if a bond offers a 5.5% coupon and the price is £96 (per £100 nominal) the flat yield is 5.5/96, or 5.7%. But this ignores the fact that between now and redemption you could make an extra £4 capital gain when the bond that you paid £96 for redeems at £100 (in real terms it will be a little less, because £1 now is worth more than £1 in a year's time that's the time value' of money at work). Using a slightly more fiddly calculation a redemption yield (GRY) or yield to maturity (YTM) factors that in.

3. Price and default risk

Shares are risky dividends can get cut, prices can fall sharply, and firms can go bust. But bonds have risks too. Yes, if a company goes bankrupt, bondholders are higher up the queue for a payout than shareholders, but that doesn't mean they won't take a hit. That's where credit ratings count. NG's bond, for example, is rated BBB, pretty much the lowest it can go and still be called investment grade', partly because the company is heavily indebted. So don't fall for any sales patter that suggests bonds are safe' they are just safer than shares, which isn't necessarily saying much.

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And remember that the price of bonds, like shares, goes down as well as up. Between issue and redemption, a bond's price is determined by supply and demand. So if you cash in a retail bond by selling it before the redemption date, you might end up getting back less than you paid for it.

4. Tax

Share buyers are used to being hit by the tax office in at least three ways. First, you pay stamp duty at 0.5% of the purchase price. Second, there's income tax on dividends. Third, there's capital gains tax (CGT) on any profit you make.

The good news for retail bond buyers is that you don't have to pay stamp duty. Income tax and CGT will still be due, but conveniently most retail bonds are also what HM Revenue & Customs calls qualifying'. This means you can tuck them away in an individual savings account (Isa) or self-invested personal pension (Sipp) and shield them from both income tax and CGT.

5. Minimum investment limits

If you are used to buying shares, the minimum investment for most retail bonds may be higher than you're used to. For example, while you can pick up just a handful of NG shares at the current market price of around £6.30, if you want to buy the retail bonds at issue, the minimum investment is £2,000. After that your investment must be in lots of £100 nominal value.

6. How to trade

Most FTSE 100 shares can be easily bought and sold through almost any internet trading platform. It's a different story for retail bonds. Although these are easier to trade than they once were, you can't assume that your broker will have automatic access to the full retail bonds list. So check that they actually offer what you want to buy, and always make sure you know how much it will cost to trade.

This article was originally published in MoneyWeek magazine issue number 557 on 30 September 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.