When an investor buys a bond – sometimes called a fixed interest investment – in effect he or she lends money to the issuer, with a defined rate of interest and maturity date making it clear how much will be paid back on a certain date.
Jason Hollands, managing director of business development and communications at Bestinvest, said: “It’s basically an IOU issued by a government, company or another institution. You are lending them some money that they will pay back with interest at a later date.”
While equities – shares in companies – provide the potential for capital growth because they can rise or fall in value, a bond does not.
“Over its life there’s no capital growth in it at all, because you will simply get back what you lent,” Hollands explained.
This means they are far less volatile than equities, so they are often used by investors to provide a more secure part of their portfolio that isn’t as sensitive to stock market movements. However, bond prices can fluctuate because they can be traded by investors on the secondary market.
Bonds can be bought and sold for a price above or below the original capital value, and bond managers make such trades in their funds, attempting to judge the changing fair value of the instruments.
Price fluctuations are usually much less volatile than those of equities, however, which is one source of their appeal.
“Historically they have appealed to investors who want low levels of volatility or to those who are income investors and want yield,” Hollands explains.
In recent years the low level of volatility has become particularly attractive to investors, given the large falls and high levels of volatility in stock markets.
UK Gilts and US Treasuries vs indices over 10 years
Source: FE Analytics
However, avoiding market nosedives also means investors miss out on a market rally and at a time when yields on bonds, particularly government, are at all-time lows, investors need to consider how to combat the threat of inflation in more cautious portfolios.
Inflation, a fall in the value of currency, can erode the real value of a bond, particularly one with a longer maturity date. If the currency you are paid back in is worth less than it was when you bought the bond, you have less real purchasing power.
Bond investors have had to pay close attention to the issue in the post debt crisis world, with inflation being used by certain governments, including the UK, to reduce their debts by diminishing the value of the currency they are denominated in.
Nonetheless, investors have been prepared to effectively pay governments such as the UK, Germany and the US to lend them money, as the interest rates on their bonds have dipped below inflation rates.
Hollands explains that this is partly due to fears equity markets could take another 2008-style tumble and the desire to insulate against high levels of volatility, but also to do with changes to regulation and pensions.
He said: “There have been big regulatory changes, for example insurance companies are subject to new solvency rules that are making them have to hold more bonds.”
“Also, final salary pension schemes have closed to new members. Those schemes now need to make sure there’s enough in the kitty to pay out existing promises, so they have strategies that are aiming to match their existing obligations and not trying to grow as much as possible, which is leading them into less volatile bonds.”
The reduction in yields on government bonds has led more investors to look for higher interest rates elsewhere, and therefore increased interest in the corporate bond market.
“Investors are now moving more into high quality bonds issued by companies and the same thing is happening there, yields are falling and investors are being pushed into areas such as high yield bonds,” Hollands said.
Performance of high yield bond funds vs corporate and global
Source: FE Analytics
Inflation aside, the number one risk to the holder of a bond is default – when the issuer declares that it is unable to repay the money it has borrowed from you, or has to delay payment of the interest.
The likelihood of this happening is assessed by ratings agencies and used to grade debt on a scale from D – where the issuer is judged to be already in default – to AAA, where it is judged he issuer has an extremely strong capacity to repay the capital and interest.
High-yield bonds are those with a rating below BBB and are consider higher risk by the majority of investors.
Companies with a higher risk of default and a lower credit rating tend to pay more interest, which Hollands says that investors should be wary of.
“Do not just get distracted by the highest interest on offer, because the high yield probably means a higher risk,” he said.
He adds that investors should consider carefully what they want to achieve from their investments when it comes to planning the share they allocate to bonds.
“Conventional wisdom always used to be that you should hold about a level equivalent to your age in your portfolio, so if you are fifty years old you should have 50 per cent of your portfolio in bonds,” Hollands said.
“We are in a very different world now. The reason being that in the past people invested to retire and didn’t live as long. These days you have a long period of retirement to look forward to when you won’t be working, which suggest you need to be in investments that do grow your pot, such as equities, even after you have retired.”
“None of us have a crystal ball, so are always making judgements about where markets are going, but the one thing there is certainty about is the impact of charges, so it’s always important to try to get your charges down.”
“This is especially true for bonds because charges have more effect on the end return because the investments are less volatile.”
“It’s important to ask where the charges are taken from. Some funds will take charges from the income, others will want to maximise pay-outs to investors, so will take charges from the capital.”
“There isn’t a right or wrong answer. The question is whether you want to take the income and live of it or if you are looking to maximise total return,” he said.
So, are bonds right for me?
A higher weighting to bonds offers investors a portfolio with a lower volatility, making it more suitable for investors who want to reduce the risk of losing their money while receiving interest payments.
They do have to give up the higher potential for growth that equities bring, however.
For investors looking for income, bonds also traditionally play a large role, but this is coming under pressure due to falling yields.
Because of the high popularity of the asset class, the interest investors are paid for bonds with low default risk is low, sometimes even below the level of inflation. This means that investors seeking income might want to raise their exposure to equity income funds or high-yield bond funds, both of which carry a higher risk of losing investors their capital.
That said, lower yielding bond funds – including those with a government bond focus – are certainly worth considering if investors want to hedge against the higher risk portions of their portfolio.