Bonds could be counterweight to low interest

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The search for income is ongoing for most savers, particularly those in retirement. The worry is that money built up sometimes over a working lifetime is being eroded as the interest rates offered are so low as to not even keep up with inflation.

The Bank of England has now held its base rate at 0.5 per cent – the lowest in its history – for over three years and there is no sign that it will rise. This in turn has had the effect of lowering provider deposit rates.

One way out of the spiral is to seek corporate bonds or funds of such bonds. Just as individuals sometimes need to borrow money, so do governments, firms and other organisations which can be achieved through issuing bonds.

A bond should be thought of as an IOU.

It is issued with a maturity date, often known as the redemption date. Depending on the length of time until maturity, it is referred to as short-dated, medium-dated or long-dated.

Each bond pays interest (called the ‘coupon’), which depends on how risky the issuer is considered by one of the credit ratings agencies. Whilst a UK Government bond (known as a ‘gilt’, short for gilt-edged) would be AAA rated by Standard & Poor’s because it has such a low risk of default, companies with higher risk profiles would have to pay proportionately more interest.

Investment-grade corporate bonds – bought through a stockbroker or in some instances directly from the company – usually trade at around one per cent over gilts. With gilts yielding around two per cent for 10-year issues, savers would expect to receive three per cent for outstandingly good corporate bonds.

Yet the market is currently acting in a weird way and yields are often barely above gilts. Experienced stockbrokers seek out high-yield bonds where the market weakness in the second half of last year led to rates rising towards high single digits.

This does reflect a higher degree of default risk but brokers Brewin Dolphin say “these risks are misplaced in current valuations”.

Look at the gross redemption yield (GRY), not the headline rate. The former is the internal rate of return, indicating the total return the saver will receive from purchasing the bond at a particular price and holding it to maturity. It reflects the interest paid, reinvestment of that interest, and the effect of capital gain or loss from holding the bond to maturity.

As an example, HSBC August 2019 quotes 6.25 per cent but its GRY is 4.4 per cent with an AA- rating.

Charles Stanley’s Jonathan Baker in Leeds likes Jaguar/ Land Rover 8.125 per cent May 2018. Although the bond is rated only B+, the firm has seen record sales growth and is a premium brand, owned by the Tata Group.

Many corporate bonds can be bought from £1,000 but quite often there is a minimum transaction cost, such as £40 with private client stockbrokers Killik which makes it more cost-effective to purchase £4,000 worth.

They otherwise charge one per cent on the first £15,000 and 0.5 per cent on the next £35,000.

Killik’s senior investment strategist recommends Lloyds 4.875 per cent 2024 with AAA rating and 4.6 per cent GRY, Intermediate Capital 7 per cent 2018 with BBB- (6.6 per cent GRY) and Provident Financial 8 per cent 2019 on BBB (8.44 per cent GRY).

Bonds have a place in every portfolio but the level held will depend upon your attitude to risk.

A cautious investor would typically take up 45 per cent (with 30 per cent equities, 15 per cent cash and 10 per cent commodities).

By comparison, a high risk saver would opt for up to 15 per cent (with 70 per cent equities, 10 per cent commodities and just five cent cash).

In order to reduce the risk of default on a corporate bond, a collective investment may be preferred which gives exposure to 75-150 different individual issues. The top performers here over the past three years to the end of February with dividends reinvested on a gross basis, according to research by Lipper specially prepared for the Yorkshire Post were:

• Old Mutual Corporate Bond A Acc, up 84.5 per cent;

• Henderson Sterling Bond Inc, up 84.4 per cent;

• Baillie Gifford Corporate Bond A Inc, up 82.7 per cent;

• UBS Long-Dated Corporate Bond UK Plus Acc K, up 79.3 per cent.

“Fixed interest funds reduce the volatility of equity-based investment portfolios,” says Peter Heckingbottom, Chartered Financial Planner and Deputy Managing Director at advisers Pearson Jones.

However, he cautions that “investors need to be aware that fixed interest funds do not perform well in an inflationary environment or where interest rates are rising”.

Individual corporate bonds are not protected by the Financial Services Compensation Scheme unlike funds composed of them, warns Andi Murphy of Leeds advisers AWD Chase de Vere.

Some funds focus on the best quality corporate bonds whilst others seek less secure or smaller firms where you are rewarded for the increased risk by a higher rate of interest.

A mid-risk path is taken by some collectives which invest in a combination of good and lesser quality bonds.

Murphy likes Fidelity Moneybuilder Income and M&G Corporate Bond for investment grade funds. Baker at Charles Stanley tips M&G Optimal Income and Church House Investment Grade Fixed Interest.

Two funds stand out for Martin Payne, director at Brewin Dolphin: Investec Monthly High Income, which takes an overweight position in high yield markets to generate an annual 7.5 per cent and M&G Optimal Income, which has no restrictions on where its impressive fund manager can invest although currently yielding under five per cent.

To make such a holding as tax efficient as possible, shelter it in an ISA (where the current annual limit is £10,680) or Self Invested Personal Pension (SIPP).

With investment grade corporate bond yields still low, an alternative would be to opt for equities paying good dividends which are typical paying 5.1 to 5.9 per cent.

The investor taking an equity income route should see growth as well as yield but that is another story and perhaps for another part of the portfolio.