Equities are the star performers in a typical investment portfolio. They can bring rapid growth and heavy losses, sometimes in the same day. We read about their fortunes in the newspaper and anyone with an interest in such things has an opinion on them. They can be volatile and worrying, but also thrilling and rewarding.
Bonds, on the other hand, are the steady supporting players. They work behind the scenes to bring stability to investment portfolios, as well as the organisations they help to fund. There is nothing particularly exciting about a bond, but without them, investing would be a much more chaotic business.
So, what is a bond, and why should you have them in your portfolio?
Bonds (Fixed Interest Securities)
A bond is a type of loan. This may be a corporate bond, which is a loan to a company, or a government bond. Loans made specifically to the UK government are known as gilts.
Some bonds are index-linked, which means that the value is increased in line with inflation.
When you buy a bond, you will receive regular ‘coupons’ or interest payments. This interest is fixed as a percentage of the original purchase price.
Bonds can be bought at the time of issue or traded on the second-hand market. The price of the bond can rise or fall and will be influenced by factors such as interest rates, inflation and equity prices. For example, during periods of low interest, bonds can become attractive as they are likely to produce a higher return than cash.
While the value of the bond can fluctuate, the interest payment remains fixed. For example, if the interest rate at outset is 5%, you would receive £5 in interest for every £100 invested. However, if you buy the bond on the second-hand market, the price may have risen, for example by 50%. This means that you need to invest £150 to receive your £5, reducing the effective yield to 3.33%.
At the end of the term, your capital is returned.
Risk and Reward
Bonds are considered to be a stable asset, but they are not completely without risk. Usually, the higher the risk, the higher the interest rate. The issuing organisation of the bond will usually have a credit rating, which can help to assess their solvency and ability to repay the loan.
A loan to the government of an economically stable country is likely to be lower risk than a smaller company in an emerging economy. However, the returns are also likely to be considerably lower.
If the issuer of the bond defaults on the loan, it is possible to lose your investment. But ‘creditors’ of the company take higher priority than shareholders in terms of return of capital. This is one reason why bonds are considered to be less risky than shares.
Buying and Selling
Buying bonds is as easy as buying shares. You can buy bonds either at issue or on the second-hand market.
But most investors, even those who actively trade, do not buy bonds directly. It is far easier to use the expertise of an investment manager and buy shares in a fund. This has the following benefits:
The fund manager has the expertise and resources to choose the most suitable bonds for the portfolio.
The fund also has the scale to buy a wide range of bonds from across the world at minimal cost.
Even a small portfolio can hold a diverse selection of bonds within a fund. This fund may be a general fixed-interest collective, or might specialise in a particular area. It could also be a multi-asset fund, which holds bonds as part of a wider portfolio.
It is not necessary to fully understand the ins and outs of the bond market to gain exposure to this asset class. There are hundreds of funds, portfolios and investment managers prepared to do the work for you.
The Benefits to Your Portfolio
The main benefits of investing in bonds are:
- They are not as volatile as equities and can provide a portfolio with some stability.
- The prices are not always correlated with equities. This means that when equity prices fall, bond prices can increase.
- Bonds can provide an alternative to holding high levels of cash, particularly when interest rates are low.
- Index-linked bonds offer inflation-proofing, which can help to protect the real value of a portfolio against rising prices.
- Different types of bond vary in terms of risk and reward potential. The bond portion of your portfolio can be as diversified as the equity content.
When Are Bonds Not Suitable?
Bonds are suitable for every investor but may not be appropriate in every situation. For example, a portfolio seeking speculative growth would be more likely to diversify by investing in smaller companies, commodities, or emerging markets. Holding a stable asset such as a bond could limit the growth potential within such a portfolio.
But these portfolios are usually only suitable if the investor meets the following conditions:
- Adequate cash reserve
- No expensive debt
- Main financial goals close to or fully funded through other means, whether by capital, accruing income or a defined benefit pension
- High tolerance and appetite for risk
- Significant capacity to sustain capital loss
- Investment timescale of 10 years or more
- Experienced in financial matters and capable of understanding the implications
Even if an investor holds higher-risk assets throughout their working life, the likelihood is that the portfolio will be de-risked as they approach retirement. At that point, bonds become invaluable.
So, while bonds are not necessarily included in every portfolio, it’s likely that every investor can benefit at some point in the lifespan of their financial plan.
Please do not hesitate to contact a member of the team to find out more about your investment options.
