Investment bonds

Putting your money in a range of different investment funds

Investment bonds are designed to produce medium- to long-term capital growth, but can also be used to give you an income. They also include some life cover. There are other types of investment that have ‘bond’ in their name (such as guaranteed bonds, offshore bonds and corporate bonds), but these are very different. You pay a lump sum to a life assurance company and this is invested for you until you cash it in or die.

Investment bonds are not designed to run for a specific length of time but they should be thought of as medium- to long-term investments, and you’ll often need to invest your money for at least five years. There will usually be a charge if you cash in the bond during the first few years.

The bond includes a small amount of life assurance and, on death, will pay out slightly more than the value of the fund. Some investment bonds offer a guarantee that you won’t get back less than your original investment, but this will cost you more in charges.

You can usually choose from a range of funds which can invest in, for example UK and overseas shares, fixed interest securities, property and cash. They can also offer a way of investing in funds managed by other companies, but this may lead to higher charges.

Investment risk can never be eliminated but it is possible to reduce the ups and downs of the stock market by choosing a range of funds to help you avoid putting all your eggs in one basket. Different investment funds behave in different ways and are subject to different risks. Putting your money in a range of different investment funds can help reduce the loss, should one or more of them fall.

You can usually switch between funds. Some switches may be free, but you may be charged if you want to switch funds frequently. Any investment growth at the time of a fund switch is not taxable.

Any growth in investment bonds is subject to income tax. The investment will pay tax automatically while it is running so, if you are a:

non-taxpayer – you will not have to pay any further income tax but you cannot reclaim any tax;

basic-rate taxpayer – you will not normally have to pay any further income tax; and

higher-rate taxpayer (or close to being one) – if you withdraw more than 5 per cent of the original investment amount in a year or you have made a profit when you cash in the investment, you may be liable for more income tax.

Depending on your circumstances, the overall amount of tax you pay on investment bonds may be higher than on other investments (like a unit trust, for instance). But there may be other reasons to prefer an investment bond. Or you may want to set up the investment within a trust as part of your inheritance tax planning (but note that you normally lose access to at least some of your money if you do this).

You can usually take out some or all of your money whenever you wish but there may be a charge if you take money out in the early years.

You can normally withdraw up to 5 per cent of the original investment amount each year without any immediate income tax liability. The life assurance company can pay regular withdrawals to you automatically. These withdrawals can therefore provide you with regular payments, with income tax deferred, for up to 20 years.

Maintaining a diversified portfolio

Spreading risk between different kinds of investments

When you start investing, or even if you are a sophisticated investor, one of the most important tools available is diversification. Whether the market is bullish or bearish, maintaining a diversified portfolio is essential to any long-term investment strategy.

Diversification allows an investor to spread risk between different kinds of investments (called ‘asset classes’) to potentially improve investment returns. This helps reduce the risk of the overall investments (referred to as a ‘portfolio’) under-performing or losing money.

With some careful investment planning and an understanding of how various asset classes work together, a properly diversified portfolio provides investors with an effective tool for reducing risk and volatility without necessarily giving up returns.

If you have a lot of cash – more than six months’ worth of living expenses – you might consider putting some of that excess into investments like shares and fixed interest securities, especially if you’re looking to invest your money for at least five years and are unlikely to require access to your capital during that time.

If you’re heavily invested in a single company’s shares – perhaps your employer – start looking for ways to add diversification.

Diversifying within an asset class
There are many opportunities for diversification, even within a single kind of investment.

For example, with shares, you could spread your investments between:
Large and small companies
The UK and overseas markets
Different sectors (industrial, financial, oil, etc.)

Different sectors of the economy 
Diversification within each asset class is the key to a successful, balanced portfolio. You need to find assets that work well with each other. True diversification means having your money in as many different sectors of the economy as possible.

With shares, for example, you don’t want to invest exclusively in big established companies or small start-ups. You want a little bit of both (and something in between, too). Mostly, you don’t want to restrict your investments to related or correlated industries. An example might be car manufacturing and steel. The problem is that if one industry goes down, so will the other.

With bonds, you also don’t want to buy too much of the same thing. Instead, you’ll want to buy bonds with different maturity dates, interest rates and credit ratings.

[1] Cash you put into UK banks or building societies (that are authorised by the Prudential Regulation Authority) is protected by the Financial Services Compensation Scheme (FSCS). The FSCS savings protection limit is £85,000 (or £170,000 for joint accounts) per authorised firm.

Understanding investment risk

Making informed decisions to improve your chances of achieving your financial goals
If you want to plan for your financial future, it helps to understand risk. If you understand the risks associated with investing and you know how much risk you are comfortable taking, you can make informed decisions and improve your chances of achieving your goals.

Risk is the possibility of losing some or all of your original investment. Often, higher-risk investments offer the chance of greater returns, but there’s also more chance of losing money. Risk means different things to different people. How you feel about it depends on your individual circumstances and even your personality. Your investment goals and timescales will also influence how much risk you’re willing to take. What you come out with is your ‘risk profile’.

Different types of investment
None of us like to take risks with our savings, but the reality is there’s no such thing as a ‘no-risk’ investment. You’re always taking on some risk when you invest, but the amount varies between different types of investment.

As a general rule, the more risk you’re prepared to take, the greater returns or losses you could stand to make. Risk varies between the different types of investments. For example, funds that hold bonds tend to be less risky than those that hold shares, but there are always exceptions.

Losing value in real terms 
Money you place in secure deposits such as savings accounts risks losing value in real terms (buying power) over time. This is because the interest rate paid won’t always keep up with rising prices (inflation).

On the other hand, index-linked investments that follow the rate of inflation don’t always follow market interest rates. This means that if inflation falls, you could earn less in interest than you expected.

Inflation and interest rates over time
Stock market investments might beat inflation and interest rates over time, but you run the risk that prices might be low at the time you need to sell. This could result in a poor return or, if prices are lower than when you bought, losing money.

You can’t escape risk completely, but you can manage it by investing for the long term in a range of different things, which is called ‘diversification’. You can also look at paying money into your investments regularly, rather than all in one go. This can help smooth out the highs and lows and cut the risk of making big losses.

Capital risk
Your investments can go down in value, and you may not get back what you invested. Investing in the stock market is normally through shares (equities), either directly or via a fund. The stock market will fluctuate in value every day, sometimes by large amounts. You could lose some or all of your money depending on the company or companies you have bought. Other assets such as property and bonds can also fall in value.

Inflation risk
The purchasing power of your savings declines. Even if your investment increases in value, you may not be making money in ‘real’ terms if the things that you want to buy with the money have increased in price faster than your investment. Cash deposits with low returns may expose you to inflation risk.

Credit risk
Credit risk is the risk of not achieving a financial reward due to a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.

Liquidity risk
You are unable to access your money when you want to. Liquidity can be a real risk if you hold assets such as property directly and also in the ‘bond’ market, where the pool of people who want to buy and sell bonds can ‘dry up’.

Currency risk
You lose money due to fluctuating exchange rates.

Interest rate risk
Changes to interest rates affect your returns on savings and investments. Even with a fixed rate, the interest rates in the market may fall below or rise above the fixed rate, affecting your returns relative to rates available elsewhere. Interest rate risk is a particular risk for bondholders.