Also, most bonds pay their coupons gross, without withholding tax. Investors can take advantage of this by holding qualifying bonds within an ISA, producing a tax free income for life, hopefully rolling up the full £10,000 allowance year after year to build up a meaningful sum.
4. Capital growth
Bonds are associated with income, and understandably so. But, a stream of income, if received gross and re-invested can be a powerful tool for capital growth. With the advent of low-cost and easily available tax-efficient ISA and SIPP accounts, this is now a workable strategy for the UK investor.
Tip
Seven is the magic number. A 7% income, if re-invested, will double a sum of money over a decade.
5. Diversification
A well managed portfolio should contain a variety of different assets classes; equities, government bonds, index-linked bonds, corporate bonds, property and alternative assets all have their role to play. This simple approach, also known as “not keeping all your eggs in one basket” is one of the most effective strategies for reducing risk in a portfolio. In certain economic scenarios, such as a recession, bonds will generally show an inverse correlation in price movements to equities. Note that in the 2000-2003 period, when the FTSE100 declined by nearly half from the millennium highs, longer-dated gilts saw prices rise over the same period (as can be seen in the following chart).
Figure 2.1: long-dated gilts v. FTSE 100 (2000-2003)
6. Benefit from falling interest rates
When an investor buys a fixed coupon bond, he or she locks in interest rates for a defined period. Because of this, falling interest rates will cause the market value of the bond to rise. Investors who buy bonds in falling interest rate scenarios will receive the double benefit of a secure income and capital appreciation of their asset.
7. Speculation
Many financial instruments offer the potential to speculate on future price movements, and bonds are no exception. Liquid government bonds are often used by traders speculating on future interest rates while corporate bonds can see sharp price movements from changes in the perceived credit quality of the issuer.
To summarise, bonds as an asset class are about income investing. This is not to say that such a strategy can not produce capital growth – the power of a re-invested stream of coupons is a powerful tool.
Historically, UK investment has been about chasing capital gains. This is perhaps due to the history and the memory of post-war inflation and the relatively (I stress relatively) lenient tax treatment of capital gains. Income gained on investments has historically gone straight on to the investor’s top rate of marginal tax.
The development and now wide acceptance of ISA and SIPP account allow bonds, and indeed other income-producing assets to be held within a simple, legal inexpensive tax shelter. This has been a game changer for the approach of many investors, and I would venture the opinion that this development has further to run over the next few decades.
The risks
All investments involve risk, and bonds are no exception. Indeed, as some savers with the Icelandic banks and their subsidiaries discovered in 2008, not even bank deposits are truly risk free. Before we go on to consider the relative risk of the fixed income and equity asset classes, it is worth taking a moment to consider the different types of risk that an investor might face. Investment risk can be broken down into roughly five categories as follows:
1. Risk of default
The risk that the issuer may be unable to return all or some of the money advanced to them. In the bond markets this is known as a default and in the unlikely event that the issuer defaults or goes bankrupt, you may lose some, or all, of your investment.
2. Market risk
The investor buys a bond at a price. This price will then fluctuate from day to day according to interest rate expectations and credit rating changes, creating a paper profit or loss. Thus, if the investor needs to sell the asset to raise funds, they face a risk of capital loss.
3. Issue-specific risk
Many bonds are issued with imbedded features such as calls, which enable the issuer to repay the debt ahead of schedule. This can be disadvantageous to the holder. However, such features are clearly laid out in the bond prospectus, so careful investors can either avoid such issues, or make contingency plans.
4. Event and operational risks
Operational risk encompasses a variety of hazards such as brokerage charges, slippage or a shift to an unfavourable or punitive tax treatment. These types of risk can be reduced through careful planning and monitoring. An example of event risk would be the issuer of the bond becoming the target of a leveraged buyout, increasing the degree of risk of lending money to the company.
5. Inflation
We can also add to this list the risk of inflation, which can reduce the real value of any asset or portfolio over time. Bonds, with their fixed interest and redemption payments are particularly vulnerable to this risk.
Chapter 3: The players in the bond markets
A market is both created by, and exists to service, the needs of its users. In this aspect the bond market is little different from any other; and understanding the types of participants and the roles that they play is key to understanding how a market operates.
At the most basic level, the market consists of bond issuers – effectively the sellers of bonds – who need to raise capital. Set against this supply are the buyers – a wide variety of investors seeking a return on their capital. Between these two shades of black and white are many shades of grey. This chapter takes a look at the main players.
Issuers
If organisations did not need to borrow money, there would be no bond market. Thus Polonius’ oft-quoted advice from Shakespeare’s Hamlet [1] to “Never a borrower or a lender be” holds little sway in the industry. Major borrows have huge and repeating funding needs and tap the deep and liquid bonds markets on a regular basis.
Issuers range from sovereign governments, through huge multinationals such as BP or Unilever down to the medium size companies – FTSE 250 midcaps such as GKN or Enterprise Inns. All are seeking competitive sources of medium-to-long term capital. Issue size will vary from around £10 million (perhaps the smallest size possible) through to a typical £100-250 million issue and up to £500 million or £1 billion. Such block-busters are known as benchmark issues, generally liquid and transparent and useful points of reference for establishing relative value in the market.
Smaller companies are generally underrepresented in the corporate bond markets. The minimum practical deal size and the associated costs make the market unsuitable for such borrowers, whose needs are better matched by venture capital or bank lending.
Common