Playing it safe in the fixed-interest market
It's fair to say that fixed-interest investments are never going to shoot the lights out when it comes to performance; their appeal lies in the fact that they can provide a comparatively safe haven during troubled times. Indeed, many top financial advisers have been telling their more cautious clients to devote at least a third of their investments to fixed interest.
Loans made to reputable governments - including UK gilts - are the safest form of fixed-interest security as governments are less likely to default. But while corporate bonds - loans made to companies - are that little bit riskier, that is compensated for by better yields.
But there are drawbacks. One is that the payouts on bonds do not grow over time, so their purchasing power is eroded by inflation. Also, most bonds are redeemed at the same price as they were issued a few years earlier, so it's hard to make significant capital gains. In contrast, dividends on shares should keep rising over the years - as can share prices.
However, while bonds may not have the money-making potential of equity-based investments, the market for them at the moment looks attractive. One reason is that their value tends to rise when interest rates are falling, as many expect them to do over the coming year as worries about the economy continue.
Another is that bonds should be less badly damaged than shares if the issuing company gets into trouble. This is because interest on bonds must be paid in full before any dividends, and bond holders must be fully repaid before the shareholders get anything if the company is forced to wind up.
When times get really tough, however, even bonds can lose value - look at the way bank bonds plummeted after the credit crisis surfaced last summer. But the better bond fund managers foresaw the dangers in the banking sector and sheltered most of their assets in gilts or in bonds issued by more defensive companies. Some of those managers believe that some of the worst hit - and therefore highest yielding - bonds could be heading for a rewarding recovery.
But Schroder Corporate Bond fund's Adam Cordery remains defensive. "I will only ease up when the headlines say no one will ever buy corporate bonds again," he says. "We expect a lot more bad news on the economy. There will be a lot of noise about companies going bust - even if only a few actually do - and that means the prices of all corporate bonds will suffer."
The trust's cautious positioning should protect investors if things deteriorate further, but may mean it misses out on any rallies. Cordery expects this year's yield on the fund to be around 6%.
John Anderson, who manages Rensburg Corporate Bond Trust, is more upbeat. He lifted its gilts exposure to 25% in 2006. This hurt its performance in the run up to the 2007 setback, but paid off handsomely thereafter. He has recently been cutting back on gilts, because he believes the markdowns in many corporate bonds have gone far enough.
"The spreads [the difference in yield between different bonds] were forecasting a level of bank defaults as great as in the Great Depression, so I've been bottom-fishing," he says. "But I'm still overweight in bonds issued by companies in defensive sectors like tobacco and food retailers."
The Invesco Perpetual Corporate Bond fund boasts the best five-year figures in the Corporate Bond sector, and its manager, Paul Reid, believes it's heading into a period when it can achieve an above-average yield plus genuine capital appreciation.
If he gets it wrong investors will suffer, but his record indicates he has a better chance than most of getting it right.
"Things are getting very interesting," he says. "Credit spreads have been tightening since the Bear Sterns rescue package, the Royal Bank of Scotland rights issue was fantastic news for their bonds, and for other financial companies bolstering their balance sheets. We'll have more economic shocks, but a lot of that's priced in, and a lot is being done to fix markets from a fixed income point of view.
"If you have your eyes open, there are some great opportunities around."
A way a company can raise capital by creating new shares and invite existing shareholders in the company to buy these additional shares in proportion to their existing holding to avoid a dilution of value, which means keeping a proportionate ownership in the expanded company, so that (for example) a 10% stake before the rights issue remains a 10% stake after it. As an added incentive, the new shares are usually offered below the market price of the existing shares, which are normally a tradeable security (a type of short-dated warrant) and this allows shareholders who do not wish to purchase new shares to sell the rights to someone who does.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.