Bonds score with savers who count on net gains

Bonds used to be the first port of call for private investors looking for a higher return than that paid by banks and building societies. But changes to the way they were issued a few decades ago have put them out of reach of ordinary savers today.

In a bid to reverse this trend, the London Stock Exchange launched a new electronic bond exchange earlier this month, designed to make it easier for small savers to buy and hold bonds directly.

Yet bond issuers continue to boycott the small investor. Last week, the UK's largest tech company, Autonomy, launched a 500 million sterling bond on the Professional Securities Market.

Paul Killik, senior partner at Killik & Co, said: "It is interesting to see Autonomy used the Professional Securities Market, rather than making it available to retail investors on the new LSE platform. The private investor is the loser."

Bonds are essentially loans, or IOUs, issued by governments, local authorities or companies, who agree to pay interest in return for an investment.

Bonds offer greater security than equities because they are less volatile. They can be particularly valuable to those approaching retirement or who have recently retired and are looking to boost their income without taking undue risk.

Forty years ago, most portfolios were top-heavy with bonds. But everything changed with the founding of the Eurobond market initially designed as an institutional forum. However, bond issuers preferred the Eurobond market, so, as the number and size of Eurobond issues increased, fixed-income securities available to small investors declined.

This removed the option of buying bonds direct, although small savers can gain exposure via bond funds. Some experts argue, though, that these are managed pooled vehicles and so have more in common with equity funds than direct bond holdings. They can also involve higher charges.

Killik said: "There is a huge amount of retail money sitting in bank and building society accounts, not earning a great deal, that would happily move toward the bond market, and that weight of money would have a material effect upon the cost of capital.

"Last spring, John Lewis, a great name for retail investors, launched a non-retail 275 million 10-year bond at 8.375 per cent. I rang to ask why, as I felt very confident that the retail brokering community could have placed the entire issue at a materially lower rate. I was told they simply followed the advice of their lead manager.

"A couple of weeks ago we saw the market struggling to get a 250m, seven-year Manchester United bond away on a 9 per cent yield, they had to offer an extra eighth to get there. Yet why an issue such as that was not made available in retail size amazes me."

Yet not everyone is convinced bonds are the answer to small investors' prayers. Brewin Dolphin director Bryan Johnston said: "Anything that helps small investors to better understand and become involved with their savings is a good thing and to be welcomed. But there are risks with bonds, the biggest of which is inflation. I want investors to be actively engaged in the market, and, certainly, all investors are advised to spread their risk, which means bonds should be an important part of every portfolio.

"But when it comes to bonds, I would probably say that a bond fund, run by a good manager, who understands what he or she is doing, is the best place for them."

So what are bonds, how can you buy them and what are the risks? Below, we answer some common questions.

What is a bond?

It is a bit like a fixed-rate mortgage, only we, the consumers, are granting the loan. Investors agree to lend a certain amount of money over a pre-agreed time, perhaps five, ten or 15 years in return for a fixed interest and their money back at the end.

Who issues bonds?

Companies issue corporate bonds, and governments also issue their own bonds, known as gilts in the UK because they were considered to be "gilt-edged" against default. Local authorities and some other public bodies also issue bonds.

Are all bonds equally safe?

No. Government bonds should be safer than corporate bonds. Rating agencies issue guidance about a bond's security. Triple A (AAA) is the most secure, down to a D. Anything over a triple B minus (BBB-) is considered safe, that is, the risk of the issuer not paying up on maturity is not high. Below this, (BB+ downwards) the risk of default cannot be discounted.

That said, the greater the risk the higher the yield.

Why are they attractive?

Bonds can give you certainty. If you buy a bond at issue, hold it to maturity and enjoy the interest meanwhile, you have a guaranteed return on savings.

However, interest rate movements can make a particular bond more or less attractive to other investors, pushing the price up or down. This in turn affects the yield.

Bondholders may, therefore, be able to sell their holding before maturity to cash in on a capital gain.

What do bonds pay?

That will depend on the company and term, but it is easy to achieve more than 5 per cent. For example, a Morgan Stanley bond maturing in November 2013 pays 5.375 per cent, a Tesco one, maturing in October, pays 6.625 per cent (see table).

How can I buy bonds?

If you want to take part in the new electronic exchange then you can buy or sell via a stock broker, although the broker will levy a commission.

The Order Book for Retail Bonds or (Orb) as it is called will give access to 49 gilts and ten corporate bonds, which are now available for buying direct. The corporate bonds include issues from companies such as Tesco, BT, National Grid, GlaxoSmithKline, Morgan Stanley, GE Capital, Enterprise Inns and a bond issued specifically for this new service by Royal Bank of Scotland. Alternatively, you can buy exposure via a bond fund, where a manager decides which securities to buy and sell on your behalf.

What are the risks?

No investment is risk-free and bonds are no exception. The biggest risk is that the issuer cannot repay the loan on maturity and defaults, so it is important to chose your governments or companies with care.

However, even more serious risks are inflation and interest rates. While well -chosen bonds should always pay up, the return may be eroded by rising inflation, or if interest rates swing suddenly against you.

With a bond you get back at maturity what you invested, but if inflation creeps up by say 3 per cent a year, over five years you have lost 15 per cent of your buying power. You can sell out at any time, but that could involve a capital loss, and will incur further costs.

The inflation risk can be off-set by opting for index-linked gilts, which protect against rising prices.

What about tax?

The income from bonds and gilts is taxable. However, this can be avoided if they are sheltered in an Isa. To qualify for Isa status, a bond must have at least five years to run.

Gilts are free from capital gains tax, as are many corporate bonds, but some will be subject to CGT.