Billions of pounds are invested in bonds. They are a core holding in many people’s portfolios and are relied upon to deliver stable income. However, they are also one of the most misunderstood assets and remain something of a mystery to many investors
Perhaps the simplest way to describe a bond is as an IOU that’s issued by either governments or public companies that need to raise money.
Buying one means you’re lending money to an issuer in exchange for a fixed rate of interest over an agreed period – and the return of your original investment.
Bonds are assessed on the likelihood of the company or government meeting its repayments by specialist agencies such as Standard & Poor’s, which awards the most trusted ones with AAA ratings.
According to Adrian Lowcock, head of personal investing at Willis Owen, bonds don’t behave like shares, and this means they can help diversify your portfolio.
“The price of bonds is generally less volatile, so investors get a more stable income, with less risk to their capital,” says Mr Lowcock.
However, investing in fixed income can seem more complicated than equities as companies generally issue one type of share but many different bonds.
“These will have different interest rates attached to them, different maturity dates (when the loan needs to be repaid) and different terms,” he explains.
A proper assessment of a bond requires an understanding of how it sits in relation to a company’s liabilities – and how sensitive it is to interest rates and inflation.
“Bonds are very technical and complex, so buying a bond issued by Tesco is not the same as buying shares in the retailer,” he adds.
According to Patrick Connolly, a chartered financial planner at Chase de Vere, buying individual bonds can be risky. “We’ve seen supposedly strong and secure companies, such as high street banks, get into financial difficulties – and these risks are greater with smaller companies,” he says.
Being heavily invested in one company that ends up getting into trouble, therefore, could hit your finances hard.
“This is especially so with individual bonds as they aren’t protected by the Financial Services Compensation Scheme,” he adds.
A less risky option is bond funds, whose managers will make the call on which bonds to buy and sell.
Such products, suggests Connolly, should feature in most investment portfolios.
“Investors should spread the risks by investing in bond funds, so if one of their underlying holdings has problems, then this won’t have a huge effect on their overall returns,” he says.
Quick guide: Are bond funds right for me?
Consider investing if…
- You are looking to diversify your overall portfolio
- You want a manager deciding what bonds to buy
- You are looking for less volatile investments
Bond funds are particularly well suited to cautious investors, such as those near or in retirement, or those who want protection against stock market falls.
“Fixed interest has historically paid a steady level of income and isn’t usually subject to significant falls in value, meaning that investors’ capital should be well protected,” he says.
The good news is there’s a wide range of such funds available – but they are likely to differ enormously, so investors need to do their homework before committing their cash.
“Bond funds can vary in terms of the amount of freedom given to the fund manager, the types of bonds they invest in, where they invest geographically, the number of holdings they have, and the term remaining on individual holdings (duration),” explains Mr Connolly.
He suggests it’s worth holding a range of bond types in order to spread your risk.
“Diversification can be achieved by investing in a number of specialist bond funds or alternatively selecting funds with a broad investment remit,” he adds.
As bond funds obviously can’t promise you a fixed rate of interest, they will usually state the target return they are aiming at, although the actual figure may vary.
The level of bond exposure you should go for depends on your attitude and capacity for risk, as well as your financial goals, according to financial adviser Martin Bamford, managing director of Informed Choice.
“More cautious investors have typically opted for higher bond allocations, as high as, say, 60% of the portfolio,” he says.
Bond funds are well suited to cautious investors
Mr Bamford also insists any bond allocation should be spread across different bond sectors, such as government debt and overseas corporate bonds, to manage risks.
“Higher-risk investors are likely to allocate more of their portfolios to domestic and global equities, so bond allocations could fall to, say, 10%-20%,” he says.
Mr Bamford’s current preference, taking into account rising interest rates, is for higher yielding and overseas bond instruments.
“There’s still a place for UK government debt, including index linked gilts, but these have become a smaller part of portfolios in the past few years,” he adds.
However, whether or not putting your money into smaller businesses is a sensible option will largely depend on your investment goals and attitude to risk.
MARLBOROUGH GLOBAL BOND
Value of £100 invested in the fund over five years
|Fund movement in year (%)||10.48||1.2||16.62||3.99||-0.21|
|Value of £100*||110.48||111.81||130.39||135.6||135.3|
* The £100 was invested on 1 January 2014. Source: Moneywise.co.uk
|Lead Manager||Geoff Hitchin|
|Total fund size||£383.6 million|
|Minimum initial investment||£1,000|
|Minimum additional investment||£1,000|
|Annual management fee||1.13%|
|Contact details for retail investors||0808 145 2500|
Fund to watch: Marlborough Global Bond
The aim of the fund is to provide income and capital growth by investing in mainly fixed interest securities.
The managers are free to invest in bonds issued by governments and companies around the world as the fund is genuinely unconstrained in its allocations to countries and regions.
It has a cautious approach that combines a macro view with bottom-up company research and is designed to capture upside while limiting the effect of falling markets.
The portfolio has more than 470 holdings, which helps to spread risk.
International bonds account for 57.9% of the fund, with 28% in UK bonds and less than 1% each in UK equity, UK gilts and alternative trading strategies.
In addition to this, around 12% is currently held in cash/equivalents, according to the most recent fund fact sheet.
Company bond holdings include household names such as Sainsbury’s, McDonald’s, Barclays, Beazley and BHP Billiton.
As far as the credit quality is concerned, 42.4% of the fund is in bonds rated BBB, with 12.6% in BB and 12.5% in non-rated bonds.
It’s a fund that’s currently recommended to clients for their portfolios by financial adviser Martin Bamford, managing director of Informed Choice.
“This fund invests in a mix of investment and sub-investment grade bonds, with around a third in the UK and the rest overseas,” he says.
“It yields a respectable 3.74% and has a low ongoing charge of 0.43%.”
Rob Griffin writes for the Independent, Sunday Telegraph and Daily Express.