Financial advisers stress that portfolios should be wide-ranging and reflect a world economy both in terms of geography and sector.
Crucially they recommend that money should be diversified among alternative financial instruments.
Bonds form a key element. They are simply loans on which the provider pays interest. The key factor is that the higher the interest, the greater the risk.
Bonds are issued by central governments and public authorities to fund expenditure through to companies which wish to expand. Energy providers and even local authorities have borrowed through bonds.
Such loans are less volatile than equities and in most cases considered less risky but to reduce this factor still further, it is sensible to use a fund or collective, which should also make it easier to redeem your money if you need to gain access earlier than planned.
There are three categories: government, investment grade and non-investment grade. Anyone looking for a steady income stream for their savings or as a defensive growth vehicle should consider bonds. For almost all bonds, the amount of interest is paid at a fixed rate from the outset and does not alter during the life of the loan. This is why they are referred to as ‘fixed interest’. In addition, the borrower promises to reimburse the capital (loan) upon maturity.
However, the capital value of a bond fluctuates in line with interest rates and inflation projections.
Bonds are particularly suited to more cautious investors, notably those near to or in retirement or who wish to provide some protection against stock market falls.
Whilst capital should be well protected through bonds, “the conventional wisdom of bonds being low risk does not necessarily work today,” warns Elizabeth Hastings, Chartered Financial Planner at adviser Chase de Vere in Leeds.
Check a bond is covered by the Financial Services Compensation Scheme. There was no protection in two ‘mini-bonds’ offered by Providence Bonds which has gone into administration. Interest of 7.5 and 8.25 per cent was offered but savers are likely to lose over £8m.
Already this year there have been 100 bond defaults: 67 in the US, 18 in emerging markets, six in Europe.
As a direct result of central bank policy, prices on bonds – particularly Government – look expensive with the possibility of a fall to come.
With UK rates incredibly low – 0.25 per cent is the Bank of England’s lowest level in its history – and given the distorting effects of ‘quantitative easing’, Government bond yields have been kept at artificially low levels for some time.
Pumping in £70bn has caused five year ‘gilts’ (Government bonds) to fall to just 0.23 per cent with 10 year returns of 0.69 per cent. If an investor pays tax, it means a negative return. This is a guaranteed loss to redemption even with income reinvested.
Part of the central buying (£10bn) has been in 270 corporate bonds which include Marks & Spencer, McDonalds, Next and rather surprisingly Apple.
Investors also need to consider how inflation can erode their money. The Retail Prices Index here rose to 1.9 per cent in September and it likely to rise further with a weak pound raising the cost of imports.
Low volatility combined with 2.8 per cent income for M&G Global Floating High Yield has impressed Jonathan Baker, Investment Director at Charles Stanley in Leeds. He also likes Polar Capital Global Convertible which combines fixed income with capital growth as the shares have the potential to convert into equity. The manager looks at the credit rating of each firm before investing.
Infrastructure funds can be included in Church House Fixed Income, paying two per cent, and commended by Baker.
In this tough environment, funds need to be flexible and use such tools as derivatives, says Adrian Lowcock, Investment Director at Architas.
The latest Bank of America Merrill Lynch global survey reported that 54 per cent of fund managers consider bonds and equities are overvalued. Low yields have caused savers to move as much as 5.5 per cent into cash.
Ahead of next month’s Presidential election, US gilts do not look encouraging either, which means investors really ought to opt for company bonds for proper returns.
High yield bonds are less influenced by interest rates than gilts. They react more to economic growth and the possibility of corporate default. With growth still reasonable in the UK and US, “this seems to be a reasonable opportunity to obtain income without too much risk to capital,” says Martin Payne, Leeds-based director of wealth manager Brewin Dolphin, recommending AXA US Short Duration High Yield, which pays 4.3 per cent.
Certain types of bond can have coupons tied to the inter-bank rate, LIBOR. Now could be an attractive time to acquire such a fund. Payne tips both M&G Global Floating High Yield and NB Global Floating Rate Income, paying 3.8 and 4.3 per cent annually.
Bond funds vary considerably in their scope with some allowing the manager a high degree of freedom, so caution is necessary.
Good managers in this field aim to protect capital rather than maximising income. Hastings likes two: Henderson Strategic Bond and Jupiter Strategic Bond.
If looking for wider exposure than the UK, consider Twenty Four Asset Management which is highly experienced in the bond sector. Payne favours its Income Fund which invests in UK and European asset backed securities and pays 6.4 per cent or, for more general fixed income exposure, its Dynamic Bond Fund, yielding 4.8 per cent.
BlackRock Fixed Income Global Opportunities with its diverse portfolio able to invest across the whole of the bond universe without constraints is tipped by Lowcock. His other tip is M&G Optimal Income, run by the experienced Richard Woolnough.
Yet M&G recently suggested that it would be better to retain money in cash than invest in debt. It manages £260bn of which almost £160bn is in fixed interest.
Chelsea Financial Services is currently not keen on bonds. “If and when interest rates rise, it will be negative for the asset class,” says its managing director, Darius McDermott, who prefers absolute return funds as a portfolio diversifier now.
Leaving aside emerging market bonds as too risky, McDermott likes in order of yield: Invesco Perpetual Monthly Income Plus (5.5 per cent), Aviva Investors High Yield Bond (5 per cent), Jupiter Strategic Bond (4.6 per cent).