by Mark Glowrey
The majority of articles that the private investor will read in the financial press, and on online media sources such as Trade2Win, focus on equities and equity linked products such as unit trust, ETFs and other types of packaged products. Yet, a quick glance in the back of the Financial Times will reveal that there is a vast universe of government and private-sector bonds to be traded, with new issues coming daily, often valued at a billion of dollars or more.
But who cares? Equities are exciting. There is always a story……. takeovers, acquisitions, disposals, results and profit warnings all keep the rumour mills spinning nicely while the high volatility of equities holds out the promise of great rewards. Double-digit gains and more are sometimes achieved over short periods of time, and a good bull run can see the holder of such instruments make a return on his investment that can be measured as a multiple of the original investment. So who would want to buy a boring old bond? The price does not move much, and who cares about the yield?
Perhaps we should think again. Over a period of time, an asset providing a consistent yield will outperform a volatile but low yielding one. Let us look at the numbers……. suppose we take an asset and hold it for a period of time, reinvesting the income as we go. What will we achieve?
| Rate | 5 years | 10 years | 20 years | 30 years |
| 5% | +28% | +63% | +165% | +332% |
| 7% | +40% | +96% | +287% | +661% |
| 9% | +54% | +137% | +460% | +1,227% |
Not bad, I think that you will agree, particularly if the gains are left to compound for longer periods!
Here’s a summary of why I think every portfolio should contain some bonds:
Predictability: Bonds differ from equities in one other very important aspect. In order to realise your profit (or loss), you must sell the instrument back to the market – at whatever price the market happens to be quoting. But when you buy a bond, the redemption date and amount are fixed in advance, so reducing your reliance on fickle market sentiment or changing liquidity.
This is a vital advantage for people who have excess cash to invest now but who know that, at a certain point in the future, they will have to meet liabilities such as school fees or retirement. What’s more, you won’t run the risk that the stock market will enter one of its unpredictable bear phases at the very time you need to convert your investments back into cash.
Income: With an ageing population in most developed countries, income becomes an increasingly valuable aspect of any portfolio. Income available from bonds is generally higher than that available from equities. Future income payments are a known quantity, unlike dividends from equities, which may be reduced or withheld entirely in times of low profitability. This makes bonds ideal if you wish to create an income portfolio. With bonds paying annually, semi-annually or sometimes quarterly, a carefully chosen bond portfolio with six or more holdings can produce a reliable monthly income.
NB: Most bonds pay their coupons gross, without withholding tax. You can take advantage of this by holding qualifying bonds within an ISA or a SIP, where they will provide a tax-free income. This is a considerable advantage over the dividend on equities, which suffer from the cruel attention of our Scottish chancellor!
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 is one of the most effective strategies for reducing risk in a portfolio, and investors should note that in certain economic scenarios, such as a recession, bond prices will generally move in the opposite direction to equities (for instance over the 200-2003 bear market).
Benefit from falling interest rates: When you buy a bond, interest rates are locked in for a defined period. Because of this, falling interest rates will cause the market value of the bond to rise. If you buy bonds as interest rates fall, you’ll receive the double benefit of a secure income and capital appreciation of your asset. If you hold bonds that mature at different dates, you can also protect yourself against rising interest rates by using the capital that returns to you on redemption to buy new bonds that offer a more competitive yield.
Trading: Any financial instrument offers the potential to speculate on future price movements – and bonds are no exception. Traders often use the highly liquid government bond markets to speculate on future interest rates, while the prices of corporate bonds can move sharply on changes in the perceived credit quality of the issuer.
Access for the private investor
So, I hear you say, how can I get involved? Surely the word of Gilts, Bunds, Treasuries and Eurobonds is only for the banks and other professional players.
To a degree, this is true, and although the US and Europe have a thriving market in fixed income securities, the UK has, as yet, not made much progress in this direction. Certainly, private investors wishing to buy £10,000 worth of bonds will receive short-shrift from the major investment banks, who generally deal in clips of $10 million and above.
However, the last few years have seen this situation improve. Bondscape is a consortium backed by fixed-income market-makers Barclays, Winterflood and HSBC. This consortium set out to provide liquidity and transparency for the private investor by creating an online platform which allows retail brokers to see (and deal on) prices for small lots across a range of Sterling and Euro denominated bonds. This platform also provides valuable information such as credit ratings, yields to maturity and other analysis. The most useful feature for private investors (who are not allowed to deal directly on the platform) is the closing price data, which provides vital transparency in this historically opaque market (see sample webpage, below). To view the full set of these these closing prices, see www.bondscape.net.
Finding a broker who will deal in bonds can present more of a problem. The average broker will have little knowledge of this area, and even less interest. Most full-service and advisory brokers will be, at a pinch, able to deal in non-Gilt bonds but the problem here lies with the charges……. Let’s face it, there is not much point of acquiring an asset with a 50bp margin over cash if you have to pay 150bp in commission. This, of course, is particularly true if one is buying short-term bonds, which may have five years or less to run to maturity.
Thus, as with all business transactions, it pays to keep your costs low. Some of the online discount brokers are now offering the ability to buy corporate bonds. This year I have been using Squaregain (www.squaregain.com), who will deal for fixed cost of £12.50 to buy a bond. This works out at around 50bp (half a percent) on a £2,500 holding, which is quite acceptable providing the bond has more than a couple of years to run.
And how about timing?
One advantage of a bond, as opposed to a share, is that eventually you get your money back! This means that a portfolio of fixed income securities with different maturity dates will provide a steady flow of cash through coupons and redemptions. Given that these cash flows will be re-invested into new bonds, over a period of time market price movements are to a large extent rounded out of the portfolios performance.
This technique, known as a “laddered” portfolio softens the effect of entering the market at too high a level, but nevertheless, it is always nice to buy at the lower end of the range, rather than the higher end!
Takeovers are one area where the active trader can pick up cheap assets. If a company is the subject of a leveraged bid, bond holders will be wary of being swamped in new debt. Thus, credit ratings for the company are downgraded (or put on review) and risk-averse institutional holders will head for the exit.
A good example of this is the GBP denominated Marks & Spencer 5.625% March 2014, a ten year bond issued in March 2004, just before Phillip Green’s attempted takeover of the retailer.
The chart shows the bond plunging in price to a low around 82% as the takeover came into play. At this level the bond had a yield to maturity of around 8.4%, good value by any standard.
Subsequent price action has seen the price make a full recovery, leaving holders fortunate enough to buy the dip with both a high-yielding asset and a decent capital gain.
So, in a nutshell, remember that equities are not the only gain in town and that owning long-term yield may well serve you better than trading short-term volatility. When reviewing your ISA and SIP choices for 2006, don’t forget to add a few bonds!
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