Stuart Ralph, investment manager at Murray Asset Management, offers his top tips on smart bond investing.
Bonds can be a good fit for anyone seeking a guaranteed flow of income, without requiring growth on the original capital. In buying a bond you are, in effect, lending money to the issuer for a fixed period in return for a fixed rate of interest (the coupon) which is usually paid annually. At the end of the time period it is intended that the value of the bond is repaid. For example, for a ten-year, £1 million bond with a coupon of 5 per cent the issuer is saying,:“In ten years’ time I will owe you £1m, and every year until then I will pay you £50,000 interest.” But there’s no guarantee that the issuer will be able to make all the “coupons” or repay the money owed at the end of the fixed term.
The yield of a bond is inversely related to its current price – meaning that if the price of a bond falls, its yield goes up. The higher the yield of a bond, the riskier it is seen to be and the greater the chance that a company or government which issued it may not be able to repay the money. During the credit crunch, when lots of quoted companies were struggling to make ends meet, one of the first things to go was the dividend. This made the bond market look a lot more attractive for pension funds and charities, who had funding obligations to meet. Needless to say, the extra demand drove bond prices up and, therefore, the yields down.
Beware of defaults
Bonds may be generally considered as more secure than equities, but that doesn’t mean you can’t lose your money. If the issuer becomes unable to make interest payments, and “defaults”, the income you were relying on can simply disappear – and the debt itself becomes significantly less valuable – indeed, may become worthless – because questions over the issuer’s ability to repay their debts will be raised and few people want an asset that’s not providing a return.
Watch out for guaranteed losers
A widespread problem at present is that bonds generally trade at a price which is related to interest rates. For example, the bond issued by the government (a gilt), which will mature on 22 January. 2016, has a rate of interest of 2 per cent. To buy today, this gilt costs around £104 for every £100 of underlying debt. So, although the 2 per cent interest will carry on being paid until January 2016, the purchaser is guaranteed to lose £4 of capital for every £104 invested today.
Timing is everything
It’s a well-known maxim that in investment, timing is important for bonds as well as for equities. In the case of the former, important factors are inflation and interest rates – so buying immediately before a Bank of England base rate decision may be a higher risk strategy.
Mix it up
Companies as well as governments issue debt of this kind. Those companies finding it more difficult to fund day-to-day activities will need to pay a high rate of interest on their borrowings – while others have the triple-A credit rating that was recently lost by the UK itself. One option for investors is to diversify with a spread of different bond types.
Read the small print
Debt issued by companies will more often than not feature as part of a tiered structure of capital, each of which has different rights. Some may be secured on specific assets, or generally on the assets of the company; some may be completely unsecured. It’s therefore important to be absolutely clear where the bonds you’re thinking of buying rank – if a firm does go bust, you may be left as empty-handed as equity shareholders.
Protect against inflation
Not all bonds have completely static interest payments. Index-linked bonds typically give a much lower rate of interest, but on the other hand, the rate will rise in line with inflation.
Reduce your risk
Individual investors wishing to gain exposure to fixed income investments should consider diversifying through holding a collective investment vehicle or fund. This provides access to the experience of an individual fund manager, and crucially provides a level of diversification that is difficult for individuals to replicate.
Know when to leave
Some of the most popular unit trusts and open-ended investment companies (OEICs) investing in bonds have billions of pounds tied up in assets which may not readily find a buyer, so getting your money out could be tricky. Don’t be caught by a trust that’s closed the exit gate for investors, even for a short time.