The Role of Bonds Within a Diversified Portfolio

As a consequence of the low interest rate we find ourselves in, savers continue to be forced to look elsewhere for ways to boost their income. A common question that we are asked is whether there are any suitable bonds funds available and if so what type of bonds might they invest in?

Well to clarify, there are four main types of bonds and bond funds; the most well known of course are gilt-edged securities or gilts for short, these are bonds issued by the UK government and as they are virtually guaranteed not to default (you would certainly hope so!) will pay the lowest yield or interest payment. During 2009 large quantities of gilts were purchased by the Bank of England under its policy of quantitative easing.

The most commonly used type of bond is probably the corporate bond. The corporate bond sector will invest primarily into the highest quality investment grade bonds (BBB rating or above). Again, the higher quality means that they don´t need to pay as much income to attract buyers as the risk of default remains low.

At the next level of the bond funds spectrum are the strategic bonds where the fund managers are given the freedom to seek out the best risk adjusted opportunities between the different graded bonds. Finally, at the other end of the spectrum, are high yield bond funds. These will largely invest in non-investment grade bonds, paying a high income to holders but with a much higher risk of default and after the recent troubles in the financial world, probably the type you would be best advised to avoid unless you were looking for speculation.

To get a better understanding, let us look at an example of how a bond actually works. A bond is basically an IOU, and in the case of this example, issued by a company – Vodafone. The investor lends the company £100 and in return will receive income of, perhaps £5 per year which equates to 5% interest. The company or issuer repays the capital at a fixed point in the future, say 5 or 10 years time (the redemption point). These bonds are tradeable just like shares. Now suppose that 5 years into the term of our example the bond price falls to £50. If you were now to buy the bond at £50 the £5 interest now equates to a 10% interest rate, which is a lot more attractive.

This is basically what happened to bond prices following the credit crisis in Autumn 2008. The risk to the investor is that the issuer of the bond (eg. Vodafone ) goes into default, and not only can´t pay the interest but also can´t repay the capital at the redemption point. It is the responsibility of the bond fund manager to calculate the risk of Vodafone going into default, which if he sees as close to zero, buying the bond for £50 for 10% interest is great business. Aside to the 10% per annum income, in 5 years he will receive back £100 compared to the £50 he paid for the bond. Of course these were exceptional circumstances and certainly not the norm for bonds or bond funds, where investors can expect a more consistent income stream with the potential of capital appreciation to keep pace with inflation perhaps.

Bonds are only one of the asset classes available to help boost your income and avoid the pitfalls of a volatile stock market, there are also a number of alternative asset classes that may also be worth considering. Through our network or Independent Financial Adviser’s, EWB have access to many different bond funds managed by the best managers available, and also a wide range of alternative income solutions that can help remove the stock market concerns. For more information and your free report, please complete our quick contact form.

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