Tim Bennett Explains: What are fixed income securities (bonds) – part 1

What are fixed income securities (bonds)? Here Tim Bennett introduces how they work and breaks down the key jargon for novice investors. Subscribe here to receive Tim’s new videos.

In this video i want to just introduce the basic features of an important asset class called fixed income securities also known as bonds and this is the world where you find words like guilts treasuries corporate bonds as well so quite a bit of jargon all odds do in this video is introduce most of the key bits of jargon that you need to get into this world of fixed

Income securities so with no more ado what are they why are they issued well in essence a fixed income security is normally issued by either a company or a government for one reason it’s to borrow money right this is one way for governments to fill the gap between the income they receive mainly tax or whether they get a bit from privatizations and so on as well

And what they spend on defense and healthcare and so on that gap needs to be filled and ious issued by governments where the uk or us on one way to do it companies use these as a source of finance two companies have various ways to fund their activities they can use organic growth which means they’re funding their growth from internal cash flows and profits or

They may need to go cap in hand to either people are prepared to buy these ious bondholders or fixed income security investors or possibly and something will cover somewhere else in another video they go to shareholders and raise equity finance instead but we’ll leave that to one side for now so in essence a good way potentially quite a cheap way for companies and

Governments to raise the cash they need fixed income security gives you a clue that they’re trying to do it in a predictable way from their point of view they want to commit to fixed coupon or interest payments because that’s easier to manage from a cash flow perspective so question is why would you buy them all very well saying well they’re issued by these people

For a specific reason or a couple of reasons why would you buy them well in brief they’re a good diversifier okay that’s partly because the less volatile than equity is now diversification is this idea of not putting all your eggs into one basket it’s the idea of spreading your wealth around with one bit the portfolio drops another bit hopefully won’t drop as much

Will stay stable so you don’t want to be all in chairs are all in property or all in cash and fixed income securities which behave a little bit like cashiers we’ll see in a moment you put your money in it the start you expect to get it out after a fixed period and you own coupons or interest in the middle offer one way of diversifying some of your equity risk all

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Right and that’s principally because they’re a wee bit more price stable than things like equities but on the other hand they offer a slightly higher return than things like cash so perhaps a good compromise in the middle they’re stable and predictable income you can get that from equities but the problem is that when companies pay their shareholders dividends the

Directors decide how much and they can be suddenly cut or changed that’s much less of a risk with fixed income securities the coupon stream that you get tends to be steady tends to be even and unless the issuer goes bust you’re quite likely to receive it over the term of the bond or iou many are easy to trade these days you can buy and sell these things through a

Broker in a very similar fashion to the way you might trade stocks and shares okay big improvements in the way these things are traded as far as retail investment investors are concerned recently and many erisa eligible now we cover isis elsewhere in detail that means you can pop many of these things into an individual savings account and shelter them from both

Income tax and capital gains tax now where these sit on the risk return spectrum i did mention this briefly just now but let’s just formalize it according to a textbook there is a trade-off between risk and return in essence in financial markets the more risk you take the higher the return you should expect and equally you shouldn’t expect higher returns and that

You’ll prepare to take a bit of risk that seems reasonable no free lunches in this world after all so cash tends to sit at the bottom of the spectrum in other words low returns now people say that’s because it’s low risk but beware the inflation impact on cash okay cash isn’t risk free but it’s generally seen as more price table for example than shares next in

A textbook come government bonds all right now there is you might say you know what what’s the extra risk for an iou issued by the british government may the government’s not gonna go bust so it’s not the risk of default true but there is a bit of price risk as we’ll see when we cover key features in a moment government bonds unlike bank accounts can go down as

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Well as up next corporate bonds now why are they next why are they above government bonds well companies are a bit riskier to invest in than governments typically especially triple-a rated high quality governments like the uk and the us companies sometimes do get it wrong okay they stopped being able to pay coupons they can even go bust right at the top shares all

Right undoubtedly riskier in many ways and say casual government io u–‘s but the long-term returns some would say justify that risks it played the right way shares can offer some pretty decent long-term returns usually above those from corporate bonds and government bonds how much above let’s take a quick look it’s his annual real returns provided by the barclays

Equity gilt study 2001 to 2011 so a snapshot really over a 10-year period so let’s have a look the percentages up the side is annual after inflation hence the word real which means after inflation returns equities a solid performance over that decade on average it does depend exactly which equities you buy clearly five percent and your real returns next government

Bonds okay and they come in just above three percent three point four percent corporate bonds come next and then cash now two things to say about this particular graph cash you might have noticed the box actually drops that’s because if you sat on cash over this 10-year period you’re actually losing money in real terms thanks to inflation and one other thing that’s

Worth pointing out here is that the textbook isn’t always right now what i mean by that is over this particular 10-year period government bonds have actually offered a better real return annually than corporate bonds wait a minute on the last slide didn’t you just say it should be other way around because at the end of the day government bonds are not risky well

That just goes to show watch out for the curveballs in financial markets over this 10-year period we’ve had governments intervening via central banks in their own bond markets buying up bonds doing things called quantitative easing again basically cut long story short distorting the market for government bonds so that ten-year period a little bit unusual don’t

Expect that to necessarily be the picture indefinitely going forward now some key features just a round off this introductory video so what sorts of things would you expect to see if you were to buy one of these corporate or government io u–‘s first of all they carry a coupon that’s also known if you have a bank account as interest and fixed income suggests the

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Amount of that coupon is fixed over time it’s the same amount each six months or a year that you hold bond they have a maturity date also known as redemption so a bit like a bank account where you put your money in leave it there and then pull it out again basically these issuers say we will give you your money back at a fixed time in the future might be ten years

Away might be twenty years away there is a date when you expect the bond to be redeemed they have a nominal value that fixes the amount of the annual coupon and also determines the amount you get back when the bond is redeemed and a typical nominal value you can see that as an amount of a bond is 100 pounds not the same as the current price however the current price

Is determined like the price of other assets by supply and demand now just mentioned earlier if you want to take away some of that price risk on say a government iou you don’t want to worry about it going down as well as up then you can hold these things all the way through to maturity all right that takes away this little wobbles in the middle that if you trade

These io u–‘s between issue and redemption then yet the price can change and just to wrap up for those people you know still not quite sure what they’re buying the reason i say that fixed income securities a bit like a bank account is the cash flow point of view you put your money in at one end you get it back out the other let’s put some years in this is now in

The middle and essentially what i’m saying is if that’s the end of year one that’s the end of year two that’s in year three that’s the end of year for you buy the bond when it’s issued its redeemed you get your money back you get your 100 pound nominal value back and in the mean time it’ll pay a series of coupons typically every six months and in that sense it’s

A little bit like holding a bank or cash account where the pattern is fairly similar so there you have it a very brief tour of the jargon associated with the asset class known as fixed income securities aka bonds you

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Tim Bennett Explains: What are fixed income securities (bonds) – part 1 By Killik \u0026 Co