Private investors have always been in thrall to equities. Bonds, on the other hand, seem a more esoteric affair. So for most people, dabbling in bonds has almost always involved piling into some kind of managed bond fund. But in today’s markets, this makes little sense. Yields on most corporate bonds are now less than 5%. In this environment, who can afford to hand over some 1.5% or 2% in management fees? That’s between a third and half of your income, straight into the fund manager’s pocket.
And this is at a time when many portfolios could do with a corporate bond boost. Mark Carney, the governor of the Bank of England, has made it pretty clear that interest rates won’t see any meaningful uptick anytime soon. We are today seeing a dangerous deflationary wave coming out of China. Weakening commodity prices and an oversupply of industrial capacity is putting downward pressure on prices. Coupled with a generally weak economic outlook, this means little upward pressure on interest rates.
Since bond prices move inversely to interest rates (lower rates mean higher bond prices and vice versa), this should all be good news for bonds. Yet jitters in the credit markets – centred on bonds issued by energy companies, as a result of falling oil prices – have seen bond prices fall across the board.
So this could be a good time for private investors to up the ante in this hitherto ignored asset class, since corporate bonds offer better value than they did a few months ago. And there’s no need to hand over a chunk of your income to a fund manager to build a bond portfolio.
Tuck your income away tax-free
Six years ago the London Stock Exchange introduced the order book for retail bonds (ORB). This is a platform giving private investors access to a selection of government and corporate bonds and through their regular broker in bite-sized amounts (traditionally, corporate bonds have traded in blocks that are too large for the average individual). Bonds listed on ORB can be held in an individual savings account (Isa) or self-invested personal pension (Sipp), allowing you to shelter your income from tax.
The great thing about a bond is that you know exactly when interest coupons are due and when the redemption will be paid. As such, bonds can be used to save for anything from school fees, to holidays, or even the purchase of a new car, ten years down the line.
Building a bond ladder
There are two important risks to understand when choosing bonds: credit risk and interest-rate risk. The way to deal with both of them is through the construction of a bond ladder. Credit risk refers to the risk that the issuer of the bond gets into financial distress, leaving it unable to repay the bond on maturity, or indeed the interest as it falls due. As with equity investing, the best defence against this is diversification. You should spread your risks both across several bond issuers and across different economic sectors.
Interest-rate risk refers to the risk that rates may rise or fall, affecting the value of your bonds. The date at which a bond matures affects the extent to which it will be affected by changes in short-term and long-term interest rates. Since nobody can be sure what the long-term outlook for interest rates is, we need to invest in bonds of different maturities.
The general idea is to continue adding rungs to our bond ladder. As each bond is redeemed, we reinvest the proceeds in a new bond with a longer maturity than anything else currently in the portfolio.
A model portfolio
In the table below, I’ve put together an example portfolio of bonds that trade on ORB. This portfolio would make economic sense for a £15,240 Isa investment (dealing costs for bonds vary between stockbrokers, but many stock brokers will allow you to trade ORB-listed for the same price as shares). If investing more, in a Sipp, say, one might consider further diversification, and depending on investment horizon, loading more of the bonds toward longer maturities.
As it is, the maturities vary from four years to 20 years, with an average of around ten. I’ve included some reasonable diversification, from rugby club Wasps through to Tesco. This portfolio offers a running yield (the income you get relative to the price you pay) of 5.7%. However, the yield to maturity (your overall return on a bond if it’s held to maturity) would be a bit lower at 5.2%. That’s because these bonds mostly trade at a premium to their face value (the price at which they will be redeemed).
|Issuer||Sector||Matures||Price (p)||Running yield||Yield to maturity|