The first warning sign is that you’ve been contacted out of the blue.  Having your email junk filter turned on is a good start. You wouldn’t reply to emails for  some “pills” or “services”, so be equally cautious if you get an offer that’ll make you money from somebody you’ve never heard of before.If you get a surprise call offering you a fabulous investment opportunity -  hang up. The trouble is that con men know this approach doesn’t really work. They’ll take the trouble to sound as if they’re helping you. It’ll maybe take them 3 or 4 calls before they get round to a sales pitch, by which time they’ve begun to get your trust. This is the dangerous moment. Beware.

If you’ve kept alert you’re now well placed to spot the next bit; the dodgy sales pitch. A common pitch tries to sell you a share that’s basically worthless or simply non existent. The chances are that even if it does exist you’ll never have heard of it. That’s really the point – the con man is trying to sell you something that’s difficult for you to check up on. They’ll maybe put you off guard by showing you information about how much the share price has gone up, or tell you that they’ve got some insider information, or compare the share with a legitimate share, which (obviously!) won’t be doing as well.

How do these guys find you? It can be quite straightforward. If you already own shares your details will be public information, armed with is information a con man will play on your familiarity with shares.Another technique the scammer might use is to play on the low returns you might be getting from your savings at present. They might offer to invest £1000 for you and promise to pay back £500 interest in a year. This sounds a lot better than the few per cent you’re getting from the bank. But, the chances are that the conman is sucking you and others into a scheme where they pay the interest to you from new money that’s come in. At some point this arrangement, made infamous recently by Bernard Madoff, will collapse. Don’t be tempted – the chances are that you’ll be a loser.Most of the scams will be run from abroad, so don’t assume that the local police or the Financial Services Authority can help.

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“Either it’s financial Armageddon, or it’s just too cheap.” That’s how John Pattullo, director of fixed income at Henderson, recently described the corporate bonds market to the Financial Times. Current prices for the best quality “investment grade” bonds suggest that the market expects a 15-17% default rate. Yet as Pattullo notes, “the worst ever five-year cumulative period since 1970 saw a 2.3% default rate”. On top of this, according to the Barclays 2008 Equity Gilt study, corporate bonds have generated a real annual return of 4.2% over the past ten years. That beats UK government bonds (”gilts”), at 3.3%, equities at 3.1% and cash, at just 2.5%. So now could be what Hargreaves Lansdown’s Mark Dampier calls “a golden opportunity” to buy bonds cheap, especially if slowing growth prompts other central banks to join the Federal Reserve in cutting interest rates. But how do bonds work – and what’s the best way in?

Bond basics

A bond is just an IOU, issued by a government (”gilts” in the UK and “Treasuries” in the US), a company, or occasionally by local authorities or other state bodies (”municipals” in the US). But unlike a traditional loan, it can be bought and sold just like a share. There are many different types, but the “plain vanilla” fixed-interest variety is the most common.

The basic principles are pretty simple. You might hand over, say £90 for a 5% three-year bond (often indicated by a date, in this case 2011) paying annual interest payments or “coupons”. The “nominal” or “par” value, which determines both the interest you receive and the redemption value, is fixed for the life of the bond. For a sterling bond, this is typically £100. So in return for your £90, you will receive three coupons of £5 and a final £100 from the issuer. That’s a total of £15 in coupons and a £10 capital gain. All of this should be reduced, or “discounted”, to reflect the fact that £5 received in say a year’s time, is normally worth more than £5 received in three years time, taking inflation and lower investment risk into account.

Why buy bonds?

For income-seekers, bonds offering decent coupons are a good option. The commonly quoted “flat” or “income” yield measures the income return by expressing the total annual coupon – many bonds pay this in two semi-annual instalments – divided by the current price. For the bond above the flat yield is £5/£90 x 100 = 5.5%. That could be compared to the return on a cash deposit or the dividend yield on shares. But what about the £10 capital gain (£100 minus 90) also available over three years? The “redemption yield” or “yield to maturity” factors this in by estimating an “internal rate of return” (defined on page 36) for the bond’s cash flows. This is a bit fiddly, but there are many online sources of these yields, such as www.bloomberg.com – or an online bond calculator can do the hard work for you. For our made-up bond, the total “yield to maturity” is about 8.95%.

But why pay £90 for that bond rather than £85, £100 or £111? Bond prices are driven by a range of factors but the three key ones are market interest rates, the length of time remaining until a bond is redeemed (or it “matures”) and default risk – how likely an issuer is to go bust.

Interest rates and bond prices

Fixed-income bond prices and interest rates tend to move in opposite directions – prices rise as rates fall and vice versa. That’s because money market interest rates affect the return you could earn by putting your cash in a savings account rather than a bond. For example, if a cash account offers 5%, but you can buy a 4% three-year bond instead, you’d opt for cash, as £5 a year beats 4% or £4. However, if the 4% bond – remember the coupon is fixed – is available for £91 and the default risk is low, you’d buy the bond. It pays you three £4 coupons and a capital gain of £9, a total undiscounted return of £21 over three years, beating £15 from the cash account. But if the cash deposit rate had been 10% rather than 5%, the bond price would have had to fall below £91 to ensure the overall return stays competitive. So the higher interest rates climb, the lower the price of fixed-income bonds and vice versa.

Maturity dates and bond prices

As a bond approaches its redemption date, its market price tends to move ever closer to the £100 (or €100, or $100, depending on the origin of the issuer) nominal value set when it was issued. That makes sense – if you know a bond will be redeemed next week for £100, you would not expect to buy or sell it before then for much more or less. But if redemption is 30 years away, far more can happen to affect the price in the interim – interest rates could change, or the issuer could go bust.

Bond volatility

Put these two factors together and you get a key risk for bondholders – price volatility. Generally, the lower the coupon and the further away the redemption date, the higher the volatility. That’s because we all prefer “jam today”, to jam tomorrow. Time, when investing, equals risk. Analysts compare bond volatility using “duration”, which captures roughly how far away in years you are from the bond’s “midpoint”. That’s the future date by which you will have received as much cash in coupons as you are still waiting to receive in coupons and redemption value. The further away that point is, the riskier the bond and the more volatile the price.

A related problem is that the inverse relationship between bond yields and interest rates follows a curve rather than a straight line. This “convexity”, which varies between bonds, means that even for bonds of similar duration, you can’t assume prices will respond the same way to a change in interest rates. For private investors, a solution that steps around having to calculate these sorts of risk is to avoid buying single bonds and just invest in a cheap, diversified product such as an exchange-traded fund (ETF).

Default risk

Some bond issuers are more likely to fail to make repayments than others. The British and US governments are deemed by the credit-rating agencies (Standard & Poors, Moodys and Fitch) to be very safe or “triple-A” rated. As such they can sell bonds at a relatively low “redemption yield” – UK gilts typically offer less than 5%. But riskier emerging market government bonds, such as those issued by Ecuador or Venezuela, have to offer more than double that. It’s the same for companies – most are deemed riskier than the UK or US government. Their credit rating, which may range from AAA down to D for “in default” influences the return investors’ demand for buying their bonds – the bigger the risk, the higher the yield. And the longer you want investors to risk their capital, the greater this effect.

As for hedging against default risk, professional investors running large portfolios have various options, including buying insurance in the form of credit default swaps (CDS). For private investors this is rarely a possibility, but there are two solutions. One is to stick to gilts and treasuries for safety, but that can mean uninspiring returns. Diversification through an ETF (or perhaps a managed fund) makes more sense. Individual company defaults are rising – insolvency rates are up by 15% on last year, according to the Insolvency Service – but owning a fund reduces the impact of any one default on a portfolio.

Other types of bond

Alongside fixed-income bonds are a host of more exotic instruments – mortgage-backed bonds, eurobonds, convertibles and so on – many of which are too expensive or simply unsuitable for private investors as direct investments. Easiest to access are “index-linked” bonds, which are less volatile than their fixed-income counterparts as they pay a coupon adjusted up or down to reflect an inflation rate. These are a good bet as general prices rise, but will suffer should deflation strike. One way to play index-linked UK government bonds without having to buy individual gilts is via the ishares UK Pound Index-Linked Gilts ETF (LSE:INXG).

What to buy

Although some individual corporate bonds are “attractively priced” says David Roberts, head of investment at Invesco, diversified ETFs are a safer and cheaper bet. For investment-grade UK corporate bond exposure there’s the ishares UK Pound Corporate Bond ETF (LSE:SLXX) with an expense ratio of just 0.2%. Safer still, but lower yield is the mixed basket of gilts represented by the ishares FTSE UK All Stocks Gilt ETF (LSE:IGLT). For an ETF that should do well if interest rates fall to support the increasingly fragile eurozone, there’s ishares Euro Government Bond 7-10 ETF (LSE:IBGM) with exposure to countries such as Germany, France and Italy. The JP Morgan USD Emerging Market Bond ETF (NYSE:EMB), which, for UK investors in particular, is also a play on the strengthening US dollar, provides a more volatile play on slowing growth in countries such as Russia, Brazil and Turkey.

Finally, state or “muni” bonds in the US are now priced, says Ying Chen Li of JP Morgan Chase, for an “unimaginable” 30% probability that individual states such as California will default in the next 10 years. The ishares National Municipal Bond ETF (AMEX: MUB) is for those who believe that the market is due a recovery.

What is an inverted yield curve?

UK gilts yield curve
Among the UK economy’s current woes is what Kim-Mai Cutler of Bloomberg calls “an anomaly known as an inverted yield curve”, the bond market’s way of saying the UK is in trouble. A yield curve plots the individual yields for similar types of bond, say gilts, against time according to their maturity dates. The resulting curve usually slopes “upward” from bottom left to top right, because if you ask an investor to take more risk by buying long rather than short, dated bonds, they demand a proportionately higher yield.

However, yields are not just about how long you have to wait to get your cash back. Other factors include expectations about interest-rate policy. For example, many bond market players – including banks and pension funds – expect rate cuts from the Bank of England to counter a potentially long recession; so long-dated, government-backed bonds carrying a decent fixed coupon suddenly look very attractive relative to cash deposits and shorter-dated bonds. This has already driven prices up and yields down.

Once the yield on long-dated gilts dips below that on short-dated ones, the “normal” curve is said to have “inverted”, usually a sign of imminent economic trouble. The yield curve for UK companies often has a similar shape but is usually above the line for (”risk-free”) gilts. The gap between the two is known as a “spread”. The lower a firm’s credit rating, the riskier its bonds and the bigger the spread.
By Tim Bennett

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Warrant

A warrant
is issued by a company and gives the holder the right to buy shares at
a particular time in the future at a price set in the present – the
exercise price. In the meantime they can be traded on the stock market.

The aim is for the exercise price to be cheaper than the future
price or projected market value. You can then sell the warrant for a
windfall
profit. But if the shares of the company never reach the exercise
price, then the warrants are worth nothing. The warrant’s value rises
when the share price rises.

Options

An option works in a similar way but is bought from a market-maker – a
professional buyer and seller of shares – rather than the company.
There are two kinds:

• A call option gives you the right to buy shares in a particular company at a fixed price within a set period.

• A put option gives you the right to sell shares in a particular company within a set period.

Traditional options last for three months and you can either buy or
sell the shares, or let the option lapse. There are also traded options
which can be bought and sold in their own right.

Remember that warrants and options are two of the riskiest forms of
investment and should be used only by those prepared for this.

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Types of account

Brokers offer three types of service:

• An execution-only service is for investors who know which shares they want to buy. As no advice is given, this service is usually cheapest.

• An advisory service gives recommendations on which shares you should buy or sell. Private client stockbrokers usually offer this service.

• A discretionary service takes over complete control of your portfolio. The stockbroker has the authority to buy and sell shares for you within agreed guidelines. This service is usually for wealthier investors, typically with at least £50,000, and is more expensive than the other options.

Dealing via the internet

Online dealing is execution only. The majority of brokers will hold your certificates in a nominee account on your behalf. All documentation goes directly to the broker and is only forwarded on to you if some action needs to be taken.

When dividends are received or shares sold, the proceeds are automatically paid into your trading account or nominee bank account. Most online brokers charge an annual administration fee to handle the paperwork associated with your account, but some offer the service for free.

Share certificates

Very few online brokers offer clients the facility to hold certificates in their own name. The main advantage of holding your own certificates is that you don’t have to sell the shares via the broker you bought them through (although it is also easy to shift your nominee account to a new broker).

Your name appears on the company register which means that dividends are sent directly to you in the form of a cheque or nominated to a bank account of your choice. Any documentation such as takeover announcements, restructuring proposals and the ‘report and accounts’ are sent directly to you and you can benefit from any shareholder perks.

The disadvantage is that settlement usually takes longer. Certificate dealing is also far more expensive as a declining number of brokers offer the service.

Questions to ask

You should ask about the type of service. Some allow you to place a price limit at which to buy or sell a stock. ‘Limit orders’ are useful if you think a stock is going to rise or fall to a certain level during the course of a day, or if the stock market is moving rapidly. Some brokers charge for the service. Others allow orders ‘out of hours’. Your request will be placed as soon as the stock market opens.

You should also ask about the amount of interest paid on cash held in nominee accounts – you might have money sitting there between deals.

If you want to deal in foreign shares, you should also check this is an option. Not all brokers allow it.

Cheaper share dealing

‘Batch dealing’ is a service that may interest smaller investors. Your buy or sell order is lumped together with others on the day you request, drastically slashing the cost. The service is cheap but it means you won’t know the exact buying or selling price until the deal is done.

Always compare prices across the board. So ask how much it is for a basic trade, for a frequent-trader service (if you expect to trade every day) and for other extras, such as the cost of a tax-free self-select Isa wrapper.

Basic trading begins at less than £6, although investors should be wary of offers that are suspiciously low – the price may rise in the future or the costs may be hidden elsewhere.

Ask whether your broker charges for moving accounts to different firms or if you need your money in a hurry. Finally, remember the additional cost of 0.5% stamp duty on buying shares.

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Clubs tend to meet once a month for a couple of hours to discuss how to play the stock market. The nominated treasurer or chairman may spend another hour or two a month extra. The group’s members – by law there can be no more than 20 – may be family, work colleagues or simply friends.

Setting up

Members decide on a monthly subscription to raise cash to buy shares. With some clubs it is as low as £10 per member, but more typically the subscription is around £25-£30. The only other expense is the broker charges for selling.

It is often easier to start up your own club with friends who share your attitudes towards stock market investing that it is to join an existing club – most are either full or wary of inviting strangers to join them.

Details of how to set up and run a club are available from ProShareClubs. The organisation was originally set up by ProShare, a not-for-profit organsiation aimed at increasing shares ownership. It is now run by financial information firm Digital Look. Registration with the organisation is free and clubs can buy a manual for £29. It offers useful guidance and backup.

Managing the money

The treasurer of a club looks after buying and selling the shares and a secretary who keeps records of the minutes. You then need to fix the monthly subscription and discuss the investment policy.

Your club also needs a constitution, the rules of which every member agrees upon and signs. Often banks or building societies want to see your constitution before they will open an account for you.

The club needs an account to deposit money, receive dividends and meet any running costs. You can have an account in the name of the club, but you need to nominate two or three people (usually the treasurer and another person) who can write cheques on behalf of the club. Members then set up a standing order to pay their monthly subscriptions into this account.

Investment ideas

Deciding what to buy depends on your club’s ideas. Investment clubs are democratic – each decision is taken by a majority vote. Decide from the start whether you will be cautious investors or risk-takers.

You buy the shares through an execution only stockbroker, who buys and sells shares for the club. He does not give advice on specific shares.

A share certificate cannot be in the name of a partnership and, technically, investment clubs are partnerships. So shares are held through a nominee company which is operated by a stockbroker which allows its name to be used for the registration of shares. A formal agreement is drawn up between the broker and the club, and two members of the club act on its behalf.

Tax implications

You must tell the Inland Revenue when you form an investment club, as with any source of income. At the end of the tax year the club’s treasurer distributes the club’s gains and income equally among the members.

Every club member should declare their apportioned share of income or gains received from investments made by the club on their annual self-assessment tax return. The usual captial gains tax exemptions apply. See our taxes guides.

You can find out more from the Inland Revenue’s investment club section. The rules for leaving the club are in your constitution, but usually you will have to give three months’ notice before you can withdraw your money. The amount you get is calculated by multiplying the number of stocks being sold by the current value, deducting brokerage fees and adding any surplus cash to his/her credit.

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