Why I'm fanatical about corporate bonds

Last Friday I showed you five good reasons to hold cash. I explained why I'm holding 25% of my portfolio in cash. That's a level some might say is crazy, given the rate of inflation. But I made my reasons clear.

And today I'm going to add fuel to the fire. I'm allocating another shocking' 25% of my assets to a class that's not considered a great sanctuary from inflation. I've got 25% in bonds.

Now, investors are often told that equities are your best bet over the long run. But most studies compare equities to gilts (government bonds) that's hardly a fair comparison. Anyway, I'm not going to bore you with some limp government bonds. There's a much bigger and more exciting bond market out there.

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I'm talking about the retail corporate bond market. I've already told you about some interesting retail bonds this year and I'll be bringing you more bond ideas in 2012.

You might not hold any bonds. In fact, the bond market is not a place frequented by most private investors. But I think it should be and I'll show you why.

Today I want to give you five reasons why I'm a bond fanatic. And then towards the end of today's piece I'll show you how to put together a portfolio of bonds to suit your needs.

Five good reasons to get into bonds

Reason No.1: Income

I think our economy is heading into troubled waters. Western economies are plagued by debt and demographics point to trouble. In this environment corporate profits may stall. As they do, equity dividends may be at risk. Unlike your dividends, bond coupons (interest payments) can't be suspended just because the company feels like it. With a bond, you know what you're getting. This year, I've shown you a couple of bonds with inflation-busting yields. This one could pay you 12%

Reason No.2: Collateral

Bonds offer varying degrees of security. The bond I just mentioned that pays 12% was issued by Britain's largest pub landlord (Enterprise Inns). It's secured by a mortgage over some 500 pubs. So even if Enterprise goes bust, holders have some tangible security. Equity holders usually get zilch in the event of bankruptcy. Not all bonds are secured on assets so it pays to do your homework.

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Tim Bennett on what you should know before you buy retail bonds.

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Reason No.3: Control

A bond portfolio offers you the chance to create an income stream precisely tailored to your needs. Whether it's for school fees, a holiday fund, or just general income, you can buy a group of bonds that pay income and capital back at specific dates. Heck, you can even buy bonds that pay inflation linked returns. That could be a great help for your retirement planning.

Unlike many of the bond-type offerings available on the high-street, the bonds I'm talking about won't tie you in. If you suddenly need cash you can sell them just like any other share although at the prevailing market price at the time, of course.

Reason No.4: Diversification

You can create a well diversified savings vehicle using various corporate bonds. There's no need to tie yourself into one financial institution. I'm going to show you how to do that in a second...

Reason No.5: Ease

Once you've put together your bond fund you can sit back and relax. Rarely do you need to manage the fund actively. That's not to say that you can't pro-actively manage your holdings if you want. Like equities, the prices tend to go up and down, so you can make profits (and losses!) with bonds.

This low interest rate environment is drawing more and more investors towards bonds. If demand continues to go up, so will prices.

Things to consider when building your bond portfolio

Bond prices are driven by two main factors. Interest rates and credit risk. Most bonds have a fixed income say 6% a year for your average medium-risk five-year bond. If interest rates suddenly go up, then your 6% doesn't look as appealing as it did. The bond falls in value. The longer the time to maturity, the more sensitive the bond is to changes in interest rates.

And if the bond issuer starts to look like it's going to go bankrupt (credit risk) then obviously investors will start dumping the bonds. The price goes down.

But there are ways around both the credit risk and interest rate risk problems.

First, you build a portfolio of different maturity bonds. Some short and some long. That way you diversify your interest rate risk.

Secondly you diversify the type of bond issuer. Let's say you pick a utility company, a pharmaceutical, a telecoms, an insurer, etc, etc.

I can't give you a specific portfolio here today, as all Right Side readers will have different circumstances. But here's a hypothetical portfolio that I'd consider:

Now I'm not recommending that you go out and buy all these bonds. What I'm showing you is a useful concept called a bond ladder. It allows you to spread your assets across several bonds with different characteristics. So you are not exposed to a single bond that could default.

This is a hypothetical portfolio with an average maturity of ten years (2021). It's medium risk and produces an income of around £6,200 a year, based on £100,000 invested equally among the bonds at today's prices.

The idea is that when the Marks & Spencer bond matures in 2014, I'd reinvest the proceeds in a new bond and keep the portfolio rolling'. That's another attraction of a bond ladder: diversification across multiple interest-rate environments. Rather than having your whole bond exposure in one bond, by having exposure to different maturities, you help to mitigate interest rate risk.

But let's say I want to take the family on a special holiday in 2014. I might then draw down on some of the Marks & Spencer 2014 bonds when they mature to pay for the holiday. You can use the bond maturities to plan for just about anything. From paying down a mortgage, to buying a new car, to covering your kids' educational costs.

The point is that you can make plans with bonds. You know your income and you know when your capital will be repaid.

Of course, even the best laid plans can turn to dust. If Enterprise Inns, for example, goes bust, I may not get my capital back in 2018 interest payments may be suspended too. Even if the bond is secured on some pubs, the valuation on the pubs may have fallen, and it could take a while to offload them.

That's why you need diversification just as you do with shares. I've given you a hypothetical portfolio with seven bonds from different sectors and different maturities. You can use many more as you wish. All the bonds I've used here are traded on the Stock Exchange's retail bond platform, and have a minimum investment of 1,000 units (ie about a grand for each one).

If you don't have enough capital to diversify, you may be better in a bond ETF. That way you can build in some international diversification too.

I'd avoid most regular corporate bond funds, though, as management fees rob you of too much of your income. If a bond only pays 5%, then you can't afford to hand over nearly half of it to a manager!

Don't get hung up on inflation

I know that many readers are concerned about inflation ripping the heart out of their bonds.

But I think you can rest easy. By my reckoning we've already suffered the worst of the current bout of inflation. I think we've got a few years to deflate now.

And anyway, I've got plenty of inflation proofing in my asset allocation to come. Keep reading The Right Side.

Useful tip: A lot of readers of The Right Side will already be familiar and comfortable with bonds. If that's you, great. But if the idea of investing in bonds is totally new to you, I recommend you watch this primer on retail bonds from my colleague, Tim Bennett.

And note that not all stockbrokers allow you to trade retail bonds. If yours doesn't, check out MoneyWeek's broker comparison page to find one that will.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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