Invest in bonds to provide the ‘ballast’ against market falls - Conal Gregory

Bonds are simply ‘IOU’ notes issued by governments, banks and businesses and should find a place in every portfolio. They are surprisingly overlooked and yet are ideal for diversification.

Defensive: Bonds issued by rock solid issuers like the US government need to pay less interest to borrow cash.

They are suited to more cautious savers, notably those near to or in retirement, as well as those who want to provide some protection against any stock market falls.

Emma Wall, head of investment analysis at broker Hargreaves Lansdown, rightly says “bonds provide a ballast to equities”.

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In return for lending money to the issuer, bondholders typically receive a fixed income, known as a coupon, until the bond is redeemed and the original loan is repaid.

Some bonds are traded like shares. This creates a secondary market where the price of the bond rises or falls depending on several factors:

Attractiveness of level of income against current interest rates

Time left to repay the loan

Credit worthiness of issuer

Political context (such as threat of nationalisation).

Bonds issued by rock solid issuers like the US government or financially robust ‘blue chip’ companies need to pay less interest to borrow money than firms with weaker finances.

Higher interest is demanded by investors in riskier bonds where there may be a question mark over the issuer’s ability to repay the loan on time or even keep up with the regular income payments due.

Most publicly traded bonds are credit-rated by independent agencies which broadly place them in two categories: investment grade (issued by more robust companies) and high yield (formerly pejoratively termed ‘junk bonds’).

The length of time that a bond has to run carries risk. One that is due to mature within three to four years is termed ‘short dated’ and will typically be less volatile in price.

Bonds with longer periods to redemption and therefore open to more uncertainty can experience greater price movements.

Historically, savers have used bonds as more defensive investments as they are usually less risky than ordinary shares and able to provide a source of income.

However, bond markets have become topsy-turvy in recent years owing to global ultra low interest rates combined with the distortion caused by central banks issuing bonds to ensure minimal borrowing costs.

Incredibly, around a quarter – worth over US$15 trillion – of the worldwide market is now trading with negative yields.

A few months ago, the German government was able to issue a 30-year bond which offered the enticing prospect of a negative return for savers to lend it cash.

“This is a crazy world and means that far from offering secure returns at low risks, buying these bonds and holding them to maturity means a guaranteed loss!” says Jason Hollands of Tilney Investment.

He warns against those bonds that offer derisory low yields as they will not keep pace with inflation with the current Retail Prices Index at 2.4 per cent.

This includes bonds issued by the UK Government, known as ‘gilts’. Ten-year-old gilts currently yield a paltry 0.63 per cent. When interest rates rise, savers will nurse steep capital losses.

Yet for those who tolerate capital movements of share prices, equity returns are far better. The FTSE All-Share yields 4.4 per cent and the FTSE All World 2.1 per cent but are riskier than government bonds.

Developed market government bonds have higher credit ratings compared to emerging market counterparts but they also have the lowest yields.

In the current environment, investors in bonds should tread with care. Leading advisers like Hollands recommend exposure through funds where there is good flexibility to roam across bond markets, both in terms of credit quality and length of term. He tips TwentyFour Dynamic Bond fund and the Janus Henderson Strategic Bond fund.

Look at the aims of a collective and the restrictions, if any, on the manager in terms of geography, level of credit rating sought and typical time to redemption.

Wealth manager Charles Stanley’s preference is actively managed funds where the manager has a specific skill set and flexibility to make both shorter term technical and longer term strategic adjustments.

Its investment manager, Adam Martell, likes Church House Investment Grade Fixed Income, which buys corporate bonds and gilts as well as preference shares and infrastructure funds. It yields 2.2 per cent.

If looking to minimise cost and protect capital, Martell favours the AXA Short Duration Fixed Income fund which purchases bonds close to redemption. It yields just 1.6 per cent.

This may be an alternative to being charged to deposit cash, which UBS and others have started.

For a basket of UK gilts, James Rowbury at Redmayne Bentley likes Lyxor Core FTSE Actuaries UK Gilts which could be “an opportunity to gain strong capital appreciation”. He also notes that the European Central Bank is to purchase corporate bonds as part of its quantitative easing programme. To participate in the sector, he tips Baillie Gifford’s Corporate Bond fund.

For value, seek the high yield end as prices have been weakened through savers worrying about slower global growth.

Consider a collective which is focused on high yield but targeting less volatile, shorter-dated bonds. In this context, Muzinch Enhanced Yield Short Term Hedged fund is tipped by Hollands.

Do not be dazzled by high yields alone. If a bond looks too good to be true, that is probably because it is unlikely to pay. It may be issued by a well-known brand or high street name but this is a cover for its dystopian reality.

“Investors should try to hold a range of different types of bonds. If investing in fixed interest to provide security in their portfolio, then it makes no sense to rely on just one type of corporate or government bond,” suggests Kelly Kirby, chartered financial planner at Chase de Vere in Leeds.

Kirby likes to use tried and trusted strategic bond fund managers who have been investing in bond markets across different cycles, notably Jupiter Strategic Bond where the focus is defensive, Baillie Gifford Strategic Bond where the emphasis is on corporate credit and Royal London Short Duration Cycle.

The latter invests at least 70 per cent in company bonds which mature in five or fewer years. It yields 3.3 per cent.

Wall’s preferences are Artemis Strategic Bond and Jupiter Strategic Bond.

Take particular care with so called ‘mini-bonds’ which are increasingly being advertised on the internet. They are often issued by small, fledgling firms and are not traded on the secondary market. This means investors may struggle to obtain their money if required before the bond matures. If the business runs into trouble, some or all of your principal may be lost. You will also not be covered by the Financial Services Compensation Scheme.

Conal Gregory is AIC Regional Journalist of the Year.