A beginner's guide to bonds

Share this

The first impression of bonds is often dull and uninteresting.

While they have none of the exotic nature of other asset classes such as property and commodities, they have been popular this year: the sterling strategic bond sector has been the highest-selling Investment Management Association (IMA) sector for the first eight months of 2011.

Global equity markets have taken a huge beating recently, with the FTSE 100 recording the largest quarterly fall for almost a decade. In times of turbulence, bonds can be a good way of protecting your capital. They typically offer a lower return than equities, but they are less risky, and are often considered a safe-haven asset.

The basics

Bonds are essentially an IOU issued by companies and governments to raise capital. Investors buy this debt, and in return, the issuer promises to pay a set amount of interest every year plus the capital at a set date in the future. Bonds are also known as fixed income and fixed interest, and that's because they pay out a fixed amount. There are two main types of bond - government bonds, also called gilts, and corporate bonds, issued by companies.

Gilts are safer than corporate bonds, as governments are less likely to go bust - although recently, this isn't what we're seeing in certain countries in the eurozone. They are issued either as short- or long-dated bonds, and it's even possible to buy a gilt for up to 50 years.

Corporate bonds are more risky, although generally considered less so than equities. Although it's unlikely a company would default, if that happens investors could lose some, or all, of their money. However, corporate bond holders are higher up the hierarchy for a payout than shareholders should the company default.

Bonds are graded in terms of credit risk, so investors have a steer on how risky their investment is. Those rated AAA to BB are known as investment-grade bonds, and are issued by the bigger, blue-chip companies and governments. Those rated BB and below are called junk bonds, and are also referred to as high-yield bonds as they pay a higher amount of interest.

Like other traded securities, bond prices can go up and down. Investors should pay attention to the yield, which is a proportion of the bond price. The two have an inverse correlation, so if the price goes up, the yield goes down. For example, if a corporate bond has a value of £1,000 and pays 5% interest for five years, the yield is 5%. But if the bond's value falls to £900, the yield rises to around 5.6%. To calculate the yield, the equation is £50/£1,000 x 100, which gives a 5% yield. Then, if the bond's value falls to £900, the equation is £50/£900 x 100, which gives a yield of around 5.6%.

In addition, bonds have little correlation with the stockmarket, meaning if equities plummet, bond yields don't necessarily follow them down the plughole.

During August's market volatility, prices for bonds went up as investors piled into safe-haven assets. As a result, 10-year gilt yields fell to a record low below 2.79%, while yields on US Treasuries also fell to a low during the month.

How to invest

There are myriad ways to invest in bonds. Investors can buy individual corporate bonds through a stockbroker, or in some instances they are available direct from the company itself. "Buying individual bonds is high risk, just like buying individual shares. If the value of the bond falls or the company defaults on an interest payment then your whole investment will suffer," says Patrick Connolly, chartered financial planner at AWD Chase de Vere.

Earlier this year, the London Stock Exchange launched the Order Book for Retail Bonds, which is a platform where corporate and government bonds can be traded by retail investors. Traditionally, buying individual bonds was beyond the reach of most private investors before the launch of the retail bond market. Bonds are traded through an LSE member broker, in the same way as shares. Corporates are available from as little as £100, but the standard lot size for gilts is just £1, which offers a cheap entry point for retail investors.

A more diversified way for a first-time investor is to access them through a dedicated bond fund, where a fund manager will invest in a range of bonds on the investor's behalf.

"Retail investors should engage the expertise of a bond manager. The timing of buying a bond is very important, as is selling it. Only bond managers know the depth of the market," says Adrian Lowcock, senior investment adviser at BestInvest.

There are many different types of funds, denoting the type of bond investment it holds. Some funds will focus on the investment-grade bonds, while others will focus on high-yield bonds - but here you are rewarded for the higher risk with a higher rate of income. Finally, some funds will invest in a combination of both.

Connolly suggests choosing a fund with good-quality corporate bonds, as they are often considered a relative safe haven.

"The best quality bonds tend to do well when stockmarkets are falling. However, it would be wrong to assume that bonds cannot fall in value, they can and they do," he says. He points to the market during the credit crunch of 2008, where the average investment-grade bond fund fell by about 10%, and some fell more than 20%. In the same year, Connolly says, the average high-yield bond fund, which invests in less secure companies, fell by around 25%.

Lowcock advises against buying government bond funds at the moment. "With sovereign debt - yields on UK and US bonds are at an all-time low - investors are getting no compensation if they default. Thanks to the latest round of quantitative easing, yields might fall even further, so there's no point buying them now. The same goes for most corporate bonds."

Jon Day, global fixed income investment manager at Newton Investment Management says: "Choose a strategic or a dynamic bond fund." Strategic bond funds means the manager has a lot of flexibility and can invest wherever they find value, and that might be in investment-grade bonds, high-yield bonds or overseas bonds. Dynamic bond funds have a similar mandate, according to Day, but have an even freer approach.

More sophisticated investors could consider the range of fixed-income exchange traded funds (ETFs), which track indices comprised of a basket of bonds. However, while they are a cheap and liquid way to access the sector, they can be complex.

According to data from our sister publication Money Observer, as at 1 October, bond funds aren't setting the performance tables on fire. After a year, the high-yield, strategic bond and corporate bond sectors have all lost money, with only UK gilt funds giving a positive return over the timeframe.

What investors should be aware of

Before investing, decide why you want to hold corporate bonds. Is it to add a diversification element alongside other investments such as equities, or for a low-risk return? This will dictate which type of bond, or bond fund, to invest in.

Martin Bamford, managing director of Informed Choice, says: "Corporate bonds can make a good feature in a well-diversified portfolio for a cautious investor, although they are definitely not a straight replacement for cash in terms of risk. Unlike cash, corporate bonds carry the risk of capital loss. For an investor who is nervous about the value of their portfolio going down, holding too much of your investment portfolio in corporate bonds would be a bad idea."

Bamford adds that it's essential to understand the risk spectrum of corporates before committing any cash.

"At the junk end of the credit spectrum, corporate bonds can display much more equity-like risk and volatility, with the bond issuer far more likely to 'default' on their obligations to investors. Whilst the returns from junk bonds are higher, this is to compensate investors for these additional risks."

He suggests choosing a bond fund with a good track record and a reasonable spread of underlying assets, preferring the M&G Corporate Bond fund, managed by Richard Woolnough. "This fund has over 600 underlying holdings and has delivered a first-quartile performance over one, three and five years," he says.

Connolly recommends the Fidelity Moneybuilder Income and the Fidelity Strategic Bond funds, while Lowcock favours Kames Strategic Bond for his core strategic holding, paying 3.7% yield, and Threadneedle High-Yield Bond, paying 6.8% yield.