Bonds beat building societies as interest rates remain low

If looking for reliable income at lower risk combined with diversification, bonds are the answer. Yet they are so often overlooked as shares receive much more publicity.

Low rate bank and building society accounts are no place to put savings. A survey by Which? calculates that savers are losing out on a possible 12bn in interest by staying with ridiculously inadequate accounts. Almost half of 1,200 savings accounts pay 0.5 per cent interest or less with two paying 0.01 per cent, which means an annual return of 10p per 1,000 saved.

Savers need to earn over 4.6 per cent (the RPI) to not erode the value of their money through inflation. With the top easy access rate only paying 2.5 per cent (Santander which includes a 1.5 per cent bonus for 12 months), it's time to look elsewhere.

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Bonds, otherwise known as "fixed income securities", should play a part in any balanced portfolio with a greater proportion for those either in or getting close to retirement. There are several reasons for choosing bonds:

n Predictable income unlike dividends which are discretionary and can be reduced or not paid when a company falters or market conditions are unfavourable;

n Lower risk with defaults most unusual if the bonds are well selected;

n In a falling interest rate market, savers benefit from both capital appreciation of bonds and better value payments;

n Diversification to another asset class.

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Just as individuals need to borrow money – such as a mortgage for a home purchase – so governments and corporate bodies need to find sources of cash. In the case of states, it may be to finance infrastructure projects, such as rail and school construction. For a company, it may be build a new facility or expand to new markets.

The borrower usually declares the maturity date (sometimes called the redemption day) when the capital will be repaid and traders refer to such time periods as short-dated, medium-dated and long-dated. The interest paid until maturity (called the "coupon") is often expressed as an annual percentage rate.

This means that in exchange for lending your money, you can expect a regular interest payment. The picture is slightly complicated by the cost of the bond. It is likely to trade at either a premium or a discount to its final value and this can affect the yield. When a bond is close to paying out, its price returns close to the full repayment expected.

If a bond is issued at 1,000 with a six per cent coupon to mature in 10 years, the saver will receive 60 annual interest (assuming it has been purchased at the issue price). Upon maturity, the full 1,000 will be repaid. The yield is six per cent.

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However, if the bond's value falls to 800, the yield would increase to 7.5 per cent (60/800 x 100). If the bond rose in value to 1,200, the yield would reduce to five per cent (60/1,200 x 100). This shows that the price and yield of a bond are inversely related.

Stockbrokers refer to the gross redemption yield, which means the yield to maturity. It provides an indication of the total return the saver will receive from purchasing the bond at a particular price and holding it until maturity.

There are two main types of bond:

n Gilts (short for gilt-edged) issued by the Government and regarded as risk-free because default is considered so unlikely;

n Corporate – offered by a company instead of asking its shareholders (a rights issue) or borrowing from a bank.

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Most gilts are "conventional" which means there is a fixed interest payment twice a year but there are also "index-linked" gilts where the interest is adjusted to take inflation into account.

It's also possible to buy undated (also called "perpetual") gilts which have no fixed redemption date where the final payment is at the Government's discretion, such as 3.5 per cent War Loan issued in 1932.

With corporate bonds, savers are creditors of the company, unlike shareholders. Although usually not enjoying voting rights or enjoying future profits, bondholders have a higher claim upon assets in the event of bankruptcy. Sometimes it is possible to have a "convertible" bond where there is an option to exchange the bond for equity and in exchange for such an option, a lower interest is paid.

Savers can buy bonds directly and it is a good idea to have professional advice on timing and the best redemption date to fit your needs. Ratings agencies – such as Moody's and Standard & Poor's – evaluate bonds and split risk into "investment grade" (AAA to BBB with S&P) and "non-investment grade". Expect to receive a higher interest but greater risk of default the lower the rating.

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A bond fund could be the answer to gain more diversification and the benefits of a professional stock picker. According to research by Lipper specially for the Yorkshire Post, the top performing corporate bonds over five years are:

n M&G Strategic Corporate Bond A Inc, up 46.5 per cent;

n M&G Corporate Bond A Inc, up 34.9 per cent;

n Gartmore Corporate Bond Ret Inc, up 34.4 per cent;

n Invesco Perpetual Corporate Bond Acc, up 29.1 per cent.

The first and third set a minimum 1,000 investment and the others 500. Yet there are some under-performing funds in the sector over the same period. Losses were recorded of 9.2 per cent (Gartmore Fixed Interest), 9.1 per cent (AXA Sterling Corporate Bond) and 2.1 per cent (JP Morgan Sterling Corporate Bond).

Private client stockbrokers Killik & Co advise in this field and can help with calculations. They have a helpful booklet on the subject (020 7337 0520).

Brewin Dolphin prefer the collective route with exposure to 75-150 individual issues which reduces risk levels compared to direct investments.

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Martin Payne in Leeds tips both M&G Optimal Income (with 55 per cent investment grade debt) and Investec Monthly High Income, where the current yield is around 7.9 per cent.

One of the most interesting opportunities is the Short-Dated Corporate Bond fund offered by Smith & Williamson which invests in sterling, US and euro investment grade corporate bonds of no more than six years maturity. Utilities, food retail, oil and gas and mining are major choices for the fund.

Jonathan Baker at Charles Stanley is concerned about a bond bubble on account of the volume of money pouring into the sector which exceeds the amount pumped into technology stocks in 1999-2000.

Advisers Bestinvest say that whilst bond values have risen, they are not expensive. There are some liquidity issues for those managers stuck in lower-rated bonds. Overall expect yields around 5.5 per cent.

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With corporate bonds, savers are creditors of the company, unlike shareholders.

Low level of risk attractive

Nigel Wilcock, a 53-year-old maintenance electrician from Hebden Bridge, likes corporate bonds for their 'mid to low' risk. "I don't expect to make a fortune but don't want my savings to fall off a cliff," he says.

He invested 3,200 in the Artemis Strategic Bond Fund in October last year and placed it in an ISA to gain a tax advantage. It is a fixed interest fund focused on providing both income and capital growth with the flexibility to invest in any mixture of government bonds, investment grade and high yield corporate bonds.

Nigel intends to keep the investment either for future retirement or if an emergency arises.

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Nigel uses discount brokers Willis Owen for his investments. They ensure no initial fee and an annual management charge of just one per cent. Alan Easter, director, says, "Corporate bonds have proved extremely popular as income seekers try to find an investment that generates a regular return. People are unhappy with the interest rate they get for cash deposits and so are looking at corporate bonds."

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