Fixed Interest
Fixed interest investments are generally lower risk than equities, because they pay a fixed rate of interest until maturity, which means the cashflow from them is very predictable.
The lowest risk fixed interest investments are issued by Governments, for example gilts in the UK. These pay interest gross every six months, and they can be bought and sold at any time. Conventional gilts pay a fixed rate until maturity, so you know exactly how much interest you will receive over the period, and you know what the value of it will be when it matures. In the mean time, the price will fluctuate, as interest rate expectations change. Index-linked gilts pay a rate of interest that increases in line with inflation (RPI), and the capital value also increases in line with inflation. This means that you know what the real return will be, which makes them probably the lowest risk investment of all. The future cashflow from an index-linked gilt will depend on the assumptions you make about future inflation.
Corporate bonds are issued by companies to finance their operations, as an alternative to borrowing from the Bank. They work in much the same way as gilts, except that they are generally regarded as riskier, and so so they pay a higher rate of interest. A company may default on paying the interest, if the company gets into difficulties, and in the event of bankruptcy the corporate bondholders are higher up the pecking order than shareholders (equities), but may not receive back their full investment. Because of the risks, we normally recommend corporate bond funds, which spread the risk by investing in a wide range of corporate bonds. Some funds specialise in the lower risk end of the market, so-called investment grade investment bonds, and others specialise at the higher risk end, so-called high-yield bonds. There are also funds, often called strategic corporate bond funds, that are able to invest across the range, according to the risks and opportunities available at the time.
The difference between the income paid by corporate bonds and gilts is known as the spread. The spread was unusually high in April 2009, because the markets were fearful of defaults and bankruptcies. The reduction in the spread since then resulted in fabulous returns from corporate bond funds in 2009, and the income yield from corporate bond funds is still higher than from gilts or cash, albeit at a greater risk. With the next move for interest rates likely to be up, it is important to include funds at this stage of the cycle (April 2011) that can move across the range, to benefit from better rates available at the higher yield end of the market.