Inside Fixed Income
Fixed income – corporate and government bonds – can be an important part of a DIY investor’s portfolio delivering guaranteed income and capital protection in all but the most extreme circumstances.
Investors can choose to lend to a wide range of borrowers from SMEs to governments and the amount of interest they are rewarded with reflects the level of risk they are exposed to.
Income payments – coupons – are paid at regular intervals for the duration of the loan, and bonds can be traded in the secondary market at any time during the loan period.
DIY Investor looks at the options that exist if you wish to add guaranteed income to your portfolio and also hears from some issuers of alternative types of debt securities.
What are Bonds?
Bonds can be a valuable component of the DIY investor’s portfolio, delivering guaranteed income over a set period of time and the return of the invested capital in full at a pre-determined date.
City speak would have it that bonds are ‘debt securities issued by governments, companies and other organisations in order to raise capital’.
Well that they are – but put simply bonds are loans; the issuer of the bonds is the borrower (debtor), the holder of the bonds is the lender (creditor) and the coupon is the interest paid to the holder for lending the money (usually paid annually or semi-annually).
The maturity of the bond is the date at which the original loan is returned in full to the lender in every eventuality other than default.
Bonds are effectively “IOUs” issued by governments, companies or other organisation wishing to raise money to fund growth or restructure their debt and bought by investors such as banks, insurance companies, fund managers and individual investors who receive interest payments in return for the loan of their cash.
- The ‘issuer’ is the body borrowing the money.
- The ‘coupon’ is the rate of interest the issuer promises to pay the lender.
- The ‘maturity’ is the date at which the borrower repays the lender in full.
An issuer wanting to borrow £100 million will issue £100 million-worth of bonds at ‘par’ or 100p in the pound. The coupon is set at the point of issue and the agreed percentage is paid annually or semi-annually for the duration of the loan.
At the end of the term, each bond is redeemed at “par” – 100p – and prices quoted in the secondary market are relative to that starting, and finishing, value.
Bonds vs Equities
Bond markets were traditionally the preserve of large institutional investors – pension funds, insurance companies and wealth managers purchasing huge chunks of sovereign and corporate debt to deliver predictable long term income to their portfolios.
Individual investors now have access to fixed income markets and with guaranteed income and capital protection, bonds may play an increasing role in the DIY investor’s portfolio in the future.
When comparing the risks of bond and equity investing, bonds appear to offer a clear advantage.
Bonds vs Bond Funds
Bond funds offer the ready-made diversification of a pooled investment; a hundred or more individual bond holdings at the click of a mouse, more cheaply than individual bond purchases.
However, bond funds could be argued to be less attractive than holding bonds directly for two reasons.
The first is cost; in a low-yield environment charges levied on managed funds may have a disproportionate impact on the return.
The second reason is slightly less tangible. When an investor buys a bond, there is certainty in terms of future cash flows and barring the failure of the issuer, the return of the principal sum.
This is not the case with a bond fund which trades more like an equity with investors beholden to the future market price of the instrument in order to realise their cash, thereby adding an additional layer of risk.
What is a Retail Bond?
There will come a time when a company may wish to raise capital to fund any one of a number of business objectives which could include expansion, diversification or acquisition.
Alternatively, a business could seek to change its debt structure to either pay off more expensive loans, or reduce its dependence upon, for example, bank finance.
A range of options exist which may include ‘equity financing’ – the issuing of additional shares via a rights issue or the issuing of ‘preference’ shares – or ‘debt financing’ via the issue of a whole range of bonds, debentures, deposits, notes or commercial paper.
These products are collectively known as ‘debt securities’ and differ according to term to maturity and other characteristics.
For the sake of differentiation, corporate bonds are those issued by a company whereas gilt-edged securities – ‘Gilts’ – are bonds issued by the government.
Bonds bring certainty to a portfolio because of the guaranteed future income payments they deliver over the lifetime of the loan, but investors can also benefit from bond prices rising in the secondary market.
There are two main variables affecting demand for bonds and therefore their price – interest rates and sentiment around the risk of default of the bond.
As interest rates fall in the money markets, a bond paying a fixed rate of interest every year will become increasingly sought after by investors and its price will rise; the converse is also true, rising interest rates, particularly when coupled with inflationary pressure, render the fixed income from a bond unattractive and its price will fall.