Don’t write off bonds

The financial crisis in 2007 and 2008 may have sent investors fleeing from shares, but it's been fantastic for bonds. Not only have they benefited from frightened investors looking for safety, they've also been helped by central banks across the globe, which have driven interest rates lower and printed money to buy their own governments' bonds (which is known as quantitative easing, or QE).

How do bonds work?

And it's not just a phenomenon of the financial crisis ever since the early 1980s, interest rates worldwide have been falling along with inflation, which gave rise to a long bull market in bonds. This gave investors very good returns without the risks and worries of owning shares.

However, last year the bond bull market stalled. On the one hand, the Federal Reserve in the US is slowing down its rate of QE (what's been called the taper').Meanwhile, many investors are starting to worry that inflation will rear its ugly head again as the global economy recovers, and eat into bond returns.

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As most bonds pay a fixed amount of income (interest) each year on top of paying back the original money invested, higher inflation is toxic for them it reduces the level of real' returns they produce.

As a result, you won't find many people extolling the virtues of bonds, with many preferring shares this year. But while bonds do have risks, it's never good to have all your eggs in one basket.

Diversification is vital, because the economic outlook may change more rapidly than anyone expects you need a mix of assets in your portfolio to defend against that. Bonds could also still be a reasonable place to invest for income.

Consider company debt

For a start, unlike governments, firms can't print their own money to pay investors. When a firm borrows money by issuing a bond, it needs to make profits and generate cash to pay interest and repay capital when the bond matures (ie, when the loan term is up).

This makes corporate bonds riskier than government bonds, which is reflected in a higher interest rate or yield.

There are two main types of yield to look out for. The income yield is the bond's annual interest payment divided by its current price. The gross redemption yield shows what you would get if you buy the bond now and hold it until it matures.

Why buy bonds over shares?

If you want to invest through a tax-efficient individual savings account (Isa), which is a good idea as bond interest is taxable, the bond must have at least five years until it matures, otherwise it will not qualify.

Three main risks

The risk is that weak businesses may lack the cash to pay the interest on their bonds and investors could lose money.

That's why it is important to look at the type of business that is issuing the bond. A big company that can control the prices of its products is often a much better bet for an investor than a smaller one.

Make sure the company doesn't have too much debt. Look at how many times its operating profits cover its interest payments (interest cover).

Finally, look at a bond's sensitivity to changes in interest rates. This is given by a figure known as modified duration', which tells you the percentage change in price for a given percentage change in interest rates.

The higher the figure, the more sensitive a bond price is to rate changes. Long maturity bonds have higher durations and are therefore seen as being more risky if interest rates rise. But you can make money on them if rates fall.

Below are four bonds from solid blue-chip companies with income yields of around 5%. The one thing to watch is that all have fairly long maturities, which makes them more vulnerable to rate rises.

A one percentage point rise in interest rates would cause the price of the BT bond to fall by 10.4%. However, if you do plan to hold to maturity, the key risk is opportunity cost that rates rise and you miss out on the chance to get better returns elsewhere.