Bonds offer investors, in theory, a lower-risk alternative to equities
and one that defines beforehand exactly how much they can expect to receive in returns on their capital.
When an investor buys a bond – sometimes called a fixed interest investment – in effect they are lending money to the issuer, with a defined rate of interest and maturity date making it clear how much will be paid back on a certain date.
It is essentially an IOU issued by a government, company or another institution. You are lending them some money that they will pay back at a later date, and in the meantime they will pay you interest.
– shares in companies – provide the potential for capital growth because they can rise or fall in value, a bond does not.
If you hold a bond until the end of its life, you will get back the same amount you invested, although you will receive interest payments in the meantime.
This means they are far less volatile
than equities, so they are often used by investors to provide a more secure part of their portfolio
that isn’t as sensitive to stock market movements. How do bond funds make money?
Bond prices fluctuate as they are traded by investors on the secondary market
Bonds can be bought and sold for a price above or below the original capital value, and bond managers make such trades in their funds, attempting to judge the changing fair value of the instruments.
Price fluctuations are usually much less volatile than those of equities, however, which is one source of their appeal.
In recent years the low level of volatility has become particularly attractive to investors, given the large falls and high levels of volatility in stock markets.
However, many investors hold bond funds for the income they provide. Bonds pay investors a regular coupon
which investors can withdraw or reinvest in their funds as they wish. What are the main risks?
Investing in bonds means missing out on the potential upside of equities as well as the downside.
Inflation, a fall in the value of a currency, is also a risk, as it can erode the real value of a bond, particularly one with a longer maturity date.
If the currency you are paid back in is worth less than it was when you bought the bond, you have less real purchasing power.
Another major risk to the holder of a bond is default – when the issuer declares that it is unable to repay the money it has borrowed from you, or has to delay payment of the interest.
The likelihood of this happening is assessed by ratings agencies and is used to grade debt on a scale, ascribing "credit ratings" to the different bonds.
Companies with a higher risk of default and a lower credit rating tend to pay more interest, which investors need to be aware of.
Investors should also take note of the charges on bond funds. Some will take charges from the income, others will want to maximise pay-outs to investors, so will take charges from the capital, thus decreasing the amount of money producing an income and depleting the investment.
Does 'fixed income' mean that your investment has a 'fixed' return?
The coupon (the interest a bond pays) and the principal are both fixed when a bond is first issued. This means that if you buy a £1,000 bond at that point with a 10 per cent annual coupon you will receive £100 a year and £1,000 at the end of the bond’s lifetime – if you hold it until that point. Payments may be six-monthly rather than annual, meaning you will receive £50 twice.
Both the final payment and the coupons are guaranteed – if the company doesn’t pay them then they have defaulted on their debts and they are bust.
However, the price of the bond will vary over its life depending on how attractive the cash flows – the coupon and the principal – are deemed by the market, and the majority of people do not buy a bond at the point when it is issued, so they may pay more or less than the original price.
What investors think about the creditworthiness of the business and the attractiveness of alternative investments will also affect that price. Investors might pay £900 for a bond that will pay you £1,000 at maturity and £100 a year because there is some doubt about how likely the company is to survive, so that final payment may never materialise.
Similarly, you might pay £1,100 for the same cash flows if you think they are worth more because the company in question is very financially secure. Bond managers make these calculations when they buy and sell.
This means that the return of an investor will be not just the coupon, but the difference on price between what they pay for the bond and what they receive at the end. For example, if you pay £900 for a bond and receive 100 a year for three years then £1,000 back, you have made £400, not accounting for inflation and the time value of money.
There are floating rate bonds that have coupons and principals that are linked to inflation, LIBOR or some similar index, and their value varies over the life of the bond, offering investors protection from the eroding effects of inflation.Are bonds negatively correlated with equities?
Bonds and bond funds are traditionally perceived to be a 'safe haven' offering a degree of stability which equities lack.
When a company goes bankrupt bondholders are further up in the pecking order when it comes to who gets paid, so to some extent that perception is correct, however historical evidence suggests that bonds are not truly negatively correlated with equities - and when equities are in freefall, bondholders are unlikely to see their investments surge forward.
Higher yielding bonds in particular are unlikely to show negative correlation with equities. Bonds tend to pay a higher yield if the company which issues them does not have the credentials to attract investors with a lower yield; which can mean the company is in a more precarious position.
If equity markets are struggling, high yield bonds (sometimes known as junk bonds) can also witness volatility - because it is here that you are most likely to find companies which face difficulty and may not survive.
Absolute return bond funds are the exception to this rule, but they are by no means typical. This type of fund uses derivatives and specialist types of bonds to aim to deliver positive returns in all market conditions – i.e. even when conventional bonds are losing money You can learn more about this absolute return bond funds here
.Why would an investor allocate money to fixed income in a bull market?
Many professional and private investors believe that diversification of your assets
is the best way to protect yourself from volatility - because different elements of a diversified portfolio will perform well at different times.
Investors might buy into fixed income during a bull market because fixed income valuations are cheap - as the majority of investors are pursuing growth assets - and this allows them to build up a position in fixed income at an efficient price; and do so before the market turns, when their fixed income investments will become a useful defence against bearish sentiment.
Investors might also buy into higher yielding fixed income stocks during a bull market because these investments are in a relatively more attractive position during positive periods; when bankruptcies are less common, and you are more likely to see a strong capital return, as well as income, on your investment.Why would I invest in global or emerging market bonds?
Diversification is one of the key strategies investors have for reducing the risk on their portfolios both between asset classes – having mixture of bonds, equities and others – and within asset classes.
Bonds in different markets are exposed to different risks, therefore it could make sense to hold fixed interest from a number of different geographies. However, just as the major equity markets show quite a high level of correlation, so do the major bond markets.
A riskier option is to look at emerging markets bonds. These appeal to many because they offer potentially better yields. As they are seen as riskier investments, companies and governments in these markets generally have to pay a higher yield, improving total returns.
Of course, these higher returns come at the expense of extra risk, and the emerging market bond funds have suffered periods when they have seen large losses. Most investors who use them do so as a small part of their portfolio.So, are bonds right for me?
A higher weighting to bonds offers investors a portfolio with a lower volatility, making it more suitable for someone who wants to reduce the risk of losing their money, while receiving interest payments - but they do have to give up the higher potential for growth that equities bring.
For investors looking for income, bonds also traditionally play a large role, but this is coming under pressure due to falling yields.
Because of the high popularity of the asset class, the interest investors are paid for bonds with low default risk is currently low, sometimes even below the level of inflation. This means that investors seeking income might want to raise their exposure to equity income funds or high-yield bond funds, both of which carry a higher risk of losing investors their capital.
That said, lower-yielding bond funds – including those with a government bond focus – are certainly worth considering if investors want to hedge against the higher risk portions of their portfolio.
In the past, conventional wisdom was that you should hold about a level equivalent to your age in your portfolio, so if you are fifty years old you should have 50 per cent of your portfolio in bonds.
However, in the past people invested to retire and didn’t live as long. These days you have a long period of retirement to look forward to when you won’t be working, which suggests you need to be in investments that increase the value of your pot, such as equities, even after you have retired.