I have just been made redundant. I understand that there may well be a stockmarket upturn but I need to maintain the capital value of my money. Bond investments seem appropriate for my needs. Which bonds should I consider and why?
There are many types of bond available, including UK Government securities, gilts, other government bonds and corporate bonds. As you are looking for stability of capital, it is important that the right bonds are selected for you.
A range of collective investment schemes or fixed-interest funds seems appropriate. First, I must stress that the majority of funds which invest in bonds do not guarantee to protect your capital as the price of bonds moves when there are interest rate movements. If interest rates go up, then bond prices go down. If interest rates go down, then bond prices go up.
To minimise capital volatility, you should look for a fund that invests in bonds of shorter maturities. But if you are looking for total return, then you are best looking for funds that invest in longer-dated issues as you can get more return, which directly equates to your capital being more at risk.
However, the swings in your capital value in your bond fund should be a lot less than those of an equity fund.
UK gilts are currently offering low rates and therefore we could look at opportunities from other markets. One consideration is the currency risk, which can work in your favour or against you. Currency exposures can be managed and limited using either futures or currency forwards but they cannot be totally eliminated.
When considering bond funds, more important than the yield figure is the maturity dates of the bonds, which will give you a good idea of which funds are aiming to provide capital stability and which are looking to give you a higher return by taking on a lot more interest rate risk.
You may be thinking that corporate bonds are an unsuitable investment in such uncertain times because of the default risk involved and because equities have less default risk. Remember that equity paper is the lowest quality paper that a company issues. This means these risks will be reflected in good times with high absolute returns. But, in bad times, the shareholders will take the first losses. Even junk bonds rank above equity when it comes to being paid off when a company folds. So, if you have concerns about defaults at the corporate bond level, why bother investing in even riskier equity?
All corporate bonds are credit-rated on their willingness and capability to make good coupon payments and return the principal at maturity. Credit ratings go from AAA, the highest quality, down to C, very poor quality.
What we know in today's market is that an average BBB-rated bond broadly yields over 200 basis points (2 per cent) more than a similarly dated gilt. The amount of extra yield which needed to pay for default risk alone is only around 50 basis points. So you are well paid for the risk of default on repayments.
The further down the credit quality curve you go, the higher the yield you receive. The more risk you take, the greater is your potential reward. For junk bonds rated less than BBB, the yield is dependent on these bonds continuing to receive their coupons and return of principal which, in turn, depends on the issuing company being able to make these payments.
Investment-grade bonds and high-yield bonds can behave very differently.
Pension schemes invest in bonds to meet pension payments but also invest to broaden the diversification of their portfolios, which have traditionally had high equity contents.
We are moving into a world where bonds will play a much bigger part than they do today. Both governments and corporations will issue paper to meet the demand.
Since December 1990, if we compare the sterling BBB corporate bond universe with the total returns of the FTSE 100 index, corporate bonds have outperformed and in a less volatile manner. Will bonds always outperform equities? The theory says not in the long term but who knows when equities will catch up with bonds?
The selection of the bond fund provider is important. The size of the fixed-income assets managed should be taken into consideration alongside resources available, process and performance.
When your redundancy money is invested in a fixed-interest fund portfolio offered by best-of-breed investment houses, you will be content.