After years of steady gains and limited volatility for fixed income or bonds this asset class is hitting the front pages as rising yields on government debt were one of the key precursors to the recent market correction.

If yields are rising it means bond prices are falling and money has flowed out of bond funds, potentially creating some value opportunities.
A bond is essentially an IOU issued by a company, government or other body as a way of raising capital
Typically fixed income doesn’t normally attract the same amount of attention as shares, but it is nonetheless a useful option and shouldn’t be ignored. Investors looking for income will appreciate the regular coupons, especially in view of the relatively low risk to their capital, and this also makes them a valuable source of diversification for those who want a more balanced portfolio.

WHAT IS A BOND?

A bond is essentially an IOU issued by a company, government or other body as a way of raising capital. In return, the bondholders are normally entitled to receive a fixed amount of interest, the coupon, at regular intervals until the debt matures, whereupon the issuer will repay the face value of the securities.

For example, the Tesco Personal Finance 5% November 2020 bonds were issued in May 2012 and run for 8.5 years. The minimum investment at launch was £2,000 and they pay an annual coupon of 5% of the face value in two equal instalments.

Different types on bonds

The safest type of bond is generally considered to be a government bond, which is known as a gilt in the case of the UK government, as there is less chance of the issuer being unable to make the repayments as they fall due.

Corporate bonds have a slightly higher level of risk, as in the unlikely event that the issuer defaults, the bond holders could lose some, or all, of their money. Despite this issue, bonds can be much safer than shares in the same company as the prices are less volatile and the holders would be paid ahead of the shareholders if the business went into liquidation.

Investing in these sorts of bonds was beyond the reach of most private investors until the LSE launched its Order Book for Retail bonds (ORB) in February 2010. It is now home to 93 retail corporate bonds issued by well-known companies with a typical minimum investment of either £100 or £1,000, as well as 71 different gilts that can be bought for as little as £1.

Retail bonds should not be confused with mini-bonds, which are unlisted products issued by firms direct to investors and that are not subject to the same scrutiny required by ORB. These cannot be traded so investors are locked in for the full term and could lose their money if the issuer runs into difficulties as some have done in the past.

It is also important not to mix them up with fixed-rate bonds, which are fixed-rate savings accounts that are protected by the Financial Services Compensation Scheme up to a maximum of £85,000 per person, per institution. There is no such safeguard with any of the other types of bonds.

PRICES AND YIELDS

Bonds can be bought and sold and like other traded securities. Their prices can move up and down according to the market. These price movements will affect the yield to maturity – normally just referred to as the yield − for new investors.

For example, the Tesco Personal Finance bonds mentioned earlier were issued at a face value of £100, but the attractive interest rate has generated a lot of investor demand that has pushed up the price of each bond to £104.975.

Those who buy at this level would still be entitled to the £5 yearly interest, yet if they hold the bonds until they mature they would only get back the face value of £100. The yield to maturity reflects both elements and is the total return assuming all the repayments are made, expressed as an annual rate. In the case of the Tesco bonds it is currently 3.108%.

Corporate and government bonds are issued in a range of different maturities from three-month Treasury bills up to 50-year gilts and beyond, although most retail bonds fall somewhere in between these extremes.

Bonds from the same issuer with different maturities will have different yields that reflect the market’s expectations of future interest rates. If you plot the yields against the maturity dates the resultant yield curve would normally slope up towards the right showing that investors usually want a higher yield from the longer dated bonds.

RISKS AND REWARDS

The main risk of investing in a bond is that the issuer runs into financial difficulties and is unable to make the repayments resulting in a loss of interest and capital. This is known as credit risk with many bonds being given their own credit rating to provide an indication of where they stand.

Bonds issued by governments and large, well-financed blue-chip companies with less risk of default are known as investment grade, whereas the higher risk alternatives are referred to as higher yield to reflect the bigger coupons they must pay. If an issuer’s financial situation deteriorates it would have an adverse impact on the price of its bonds and vice versa.

WHAT ABOUT INTEREST RATES?

Another key area is the interest rate risk. When market interest rates increase they make the fixed interest payable on the bonds relatively less attractive. Investors will then sell them until the price falls far enough for the yields – the coupon divided by the price – to rise sufficiently to become competitive again. Higher inflation would have a similar effect and it is also worth bearing in mind that a lack of liquidity could make them difficult to sell.

The bonds that are most sensitive to these factors are the ones with farthest to go until maturity. These long duration bonds with cash flows that run well into the future have the most to lose/gain from higher/lower interest rates and will react accordingly.

Bond prices have benefited from the historically low rates of interest and many of them are now trading above their face value, although most private investors buy them mainly for their income rather than the potential capital gain. Some of the prices have recently started to weaken in anticipation of further interest rate rises.

If you are looking for a medium-term source of income the litigation finance specialist Burford’s 6.5% 2022 bonds currently have a yield to maturity of 4.3%, with a shorter term option being the insurer Beazley’s 2019 5.375% bonds that are yielding 3.03%.

HOW TO INVEST

The easiest way to invest in a retail corporate bond or a gilt is to use your stockbroker to place a deal on ORB. Most brokers allow you to register to receive details of new issues so that you can invest when they first become available. You can also buy bonds that are already trading, but you may need to phone in your order as they may not be available on your broker’s website.

Bond interest is paid gross, but the income is taxable and must be declared on your annual tax return unless you invest via an ISA or SIPP whereupon the income and gains are all tax-free.

A more diversified way to benefit is to buy a bond fund, where the manager will invest in a range of different securities to help spread the risk. The fund manager will aim to take advantage of the price movements to deliver a return based on both the income and capital gains, although investing in a fund will also incur additional costs.

One example is Fidelity Strategic Bond (GB00B5M4BD49), which like other strategic bond funds can invest in different parts of the market to take advantage of the best opportunities. It is defensively positioned with a distribution
yield of 1.9% and has returned 20.8% over the last five years. (NS)
 

Russ Mould, AJ Bell investment director, says that investors tend to adopt a buy-and-hold strategy until the next bond comes along from an existing issuer. ‘Most issues have risen on listing, so they offer a yield-to-maturity that is below the stated coupon. This means that investors who switch into the new issue with the higher coupon can compound the capital returns made on the previously-purchased bond, as well
as provide additional income.’

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