Fixed interest investments, also known as bonds and gilts, are those where a borrower agrees to pay a fixed level of interest for a fixed period of time, and then return the money or (in a small minority of cases) a fixed interest forever (or until you decide to repay).*
The most erroneous assumption is that, because such loans are only made to reliable borrowers, their money, or their return, is safe.
Profits in the fixed interest area are governed by three factors:
- Inflation – If inflation rises (or, to be more accurate, is expected to rise), then the future value of a fixed income will be worth less, i.e. the price of these investments will fall. Today you might pay £10,000 for an £800 a year income, but if inflation rises you might only pay £8,000 for it (i.e. if you paid £10,000 for an £800 pa income today, tomorrow you might only be able to sell it for £8,000, thus sustaining a capital loss of £2,000).
- Interest rates – If these are expected to increase then it means that people can get more income for their money in banks or building societies. So the value of fixed income investments will fall.
- Market sentiment towards the borrower – while the market has confidence that the borrower will meet all payments everything is fine. But should that situation change, then serious falls in the value of these investments can occur. In fact, the initial trigger of the credit crunch can be viewed as a collapse in sentiment parts of the fixed interest market relating to mortgages (a change that moved large amounts of debt from sound to risky).
It is possible to invest directly in fixed interest areas.
Gilts are loans to the Government, but most people will invest via some form of packaged investment. It is fair to say that only the more cautious investors actively opt for unpackaged non gilt fixed interest areas. In most cases exposure to this area is via professionally managed funds and investments where the manager uses fixed interest as one of the tools to produce the overall objectives of the investment.
*In some cases there is never a repayment, and the interest is paid forever (example – the permanent interest bearing shares and perpetual sub bonds issued by building societies).
The value of investments and income from them can fluctuate (this may partially be the result of exchange rate fluctuations), and investors might not get back the full amount invested. Past performance is not a guide to future performance.