A well-balanced investment portfolio will typically have exposure to the four main asset classes: cash, shares, property and bonds.
Most people will instinctively understand cash, shares and property, but bonds are a different matter altogether. They can seem complex and obscure, and many people shun them as a result. Yet bonds also have a key role to play, so what are they exactly and what can they do for you?
What are bonds?
There are two main types of bonds: government bonds and corporate bonds. They work in a broadly similar way and are issued for the same purpose, to raise money.
Governments typically issue bonds to fund their spending on, say, schools, roads and defence, while companies are typically raising money for expansion.
Investors who buy these bonds are rewarded with a regular interest payment plus a promise to return their original capital at some defined point in future, which could be anything from one month to 30 years.
This means that bonds are effectively IOUs, with investors lending their money to the issuing government or company.
Bonds are often described as fixed-income investments because you get a set interest rate for a predetermined period.
The interest rate paid on a bond is called the yield, or coupon. The maturity date is when the money must be paid back.
Say you invest $10,000 in a 10-year US Treasury, a type of bond issued by the US government, which at time of writing yields 2.36 per cent. You would get $236 a year for 10 years, then your original $10,000 at maturity.
Investors are not obliged to hold bonds until maturity, but can sell them on. They can trade at above or below their face value, depending on market conditions.
How do you buy them?
Most private investors do not buy individual or government or corporate bonds. Instead, they buy a bond fund. These are actively managed mutual funds which invest in a spread of different bonds to reduce risk.
Some funds invest in government bonds, others in corporate bonds, while some offer a mixture of the two.
Fund managers build a portfolio of bonds paying different interest rates, with different risk profiles and different maturity dates to give a more balanced return.
Corporate bond funds tend to offer the highest yields, typically between 3 and 6 per cent a year, which is more than you will get on cash.
The higher the interest, the greater the risk. Hence the relatively low 2.36 per cent return on rock solid US Treasuries.
In contrast, at the height of the Eurozone crisis in early 2012, the yield on Greek bonds briefly topped 40 per cent (they have since fallen to around 5 per cent).
Currently, two-year bonds issued by crisis-torn Venezuela are paying a mind-boggling 176 per cent, which reflects the slim chance that you will get your money back.
Who should buy them?
Ashley Owen, head of investment strategies at AES International in Dubai, says investors should consider bond funds as part of a balanced and diversified portfolio. “Bonds are less volatile than stocks and shares, which helps you counterbalance stock market swings and protect against share price falls.”
Bonds are therefore suitable for cautious investors, particularly those who are keen to preserve their capital, Mr Owen says. “Low to medium risk portfolios will have greater weighting in bonds. Government bonds show particularly low volatility.”
The older you are, the more money you should hold in bonds relative to shares, to protect the capital you have built up during your lifetime. “Bonds might also suit investors with a shorter horizon of less than five years,” Mr Owen adds.
Many investors have shunned bonds in recent years, especially government bonds, due to the low return compared to booming stock markets. Recently, an incredible $13 trillion of government bonds paid negative interest rates, which meant investors were actually paying governments to hold their money.
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What are the risks?
Do not make the mistake of thinking that bonds are risk free.
Oliver Smith, portfolio manager at trading platform IG, which has offices in Dubai, says you must consider the likelihood of losing your money in a default. “It is not unknown for a sovereign state to default, for example, Russia did in 1998, which precipitated a financial crisis, although Greece has somehow avoided a technical default.”
UK government bonds are regarded as safe despite Brexit as default chances are low because the Bank of England could simply create new money to finance the government’s debt obligations: 10-year gilts currently yield just 1.26 per cent.
The chances of a default are greater with corporate bonds, as the issuing company could go bust and be unable to repay its creditors.
Safer “investment grade” corporate bonds pay lower interest rates, while risky “high yield” or “junk” bonds reflect the greater risks investors are taking.
You can still lose money even if the issuer does not default, Mr Smith warns. Bonds pay a fixed rate of interest which makes them less attractive when inflation and interest rates are rising, as you can get a better return elsewhere.
As governments and companies issue new bonds paying higher rates of interest, the value of existing bonds paying lower interest rates falls as many investors rush to sell. When yields rise, bond prices fall (and vice versa).
If your bond pays 2 per cent a year and inflation stands at 3 per cent, you are losing money in real terms.
Steven Downey, chartered financial analyst candidate at Holborn Assets in Dubai, says bond investors must understand this interest rate risk. “Mathematically, bond prices can only go one way when interest rates rise, and that is down,” he says.
This is a growing concern as global interest rates start to rise, with the Bank of England hiking rates at the start of this month and the Federal Reserve expected to increase US rates again in December.
Governments have also been printing trillions of dollars via quantitative easing (QE) with much of this money going into bonds. This process is now set to reverse, which could hammer bond prices.
Patrick Connolly, certified financial planner at Chase de Vere in the UK, says the conventional wisdom that bonds are low risk does not necessarily hold good today. “They could suffer significant falls in the future, which would be bad news for those relying on bonds to provide security in their portfolios.”
Which funds are worth considering?
Oliver Smith at IG recommends several low-cost exchange traded funds (ETFs) investing in government bonds.
The iShares Global Government Bond UCITS ETF gives exposure to G7 bonds, including Canada, France, Germany, Italy, Japan and the US. It currently yields just 1 per cent with low total charges of just 0.2 per cent.
Lyxor FTSE Actuaries UK Gilts yields 1.6 per cent a year from UK government bonds with low charges of just 0.07 per cent.
Lyxor iBoxx $ Treasuries 1-3yr UCITS ETF yields a more generous 3.54 per cent a year from US government bonds with charges of 0.07 per cent.
Mr Downey tips iShares Emerging Market Bond ETF which gives investors access to emerging market debt denominated in US dollars. It currently yields 4.63 per cent and charges 0.4 per cent
His final choice is the iShares Emerging Market Bond Local Currency ETF, which gives investors access to emerging market debt issued in their local currency. This makes it riskier but the fund currently yields 6.1 per cent, with charges of 0.50 per cent.
Mr Connolly at Chase de Vere prefers so-called "strategic bond funds” where the manager has the flexibility to shift between different type of bond as market conditions change.
He tips three strategic global bond funds from mutual fund managers, which primarily invest in corporate bonds.
Henderson Strategic Bond currently yields 4.17 per cent with ongoing charges of 0.69 per cent, Jupiter Strategic Bond yields 3.01 per cent but with high charges of 1.48 per cent, while Fidelity Strategic Bond yields 2.12 per cent with charges of 1.19 per cent.
Today’s bond yields can seem derisory, especially once charges have been deducted, but the total return may be higher once you include capital growth from rising bond prices. For example, the Jupiter and Henderson bond funds have both given a total return of 30 per cent over five years. It may be worth taking independent financial advice to find the right blend of bonds and other investments for your personal needs.
You should also be aware of currency risk, and look for a fund and nominated in, say, dollars, sterling, euros or whichever is right for you to reduce foreign exchange volatility.
Where do you buy bonds?
The best way to buy a bond fund is through an online platform, many of which can now be accessed from the UAE.
Your options include such as AES International (aesinternational.com) IG Index (ig.com), Interactive Brokers (interactivebrokers.com), Saxo Bank (saxobank.ae), Swissquote Bank (swissquote.ae) and Internaxx (internaxx.com). They all have different charges so compare to find the best option for your needs. Bonds may be relatively safe investments, but they are riskier than they used to be.