Why would investors allocate capital to investment bonds as well as stocks? And what are the different kinds of investment bonds UK investors can diversify their portfolio with? Those are the two key questions we’ll address here.
Investment Bonds vs. Equities
The classic investment portfolio consists of a combination of two major asset classes – equities and bonds. Equities, or shares in companies, are probably what most of us naturally immediately think of when we think of investments. And for the majority of an investment portfolio’s lifetime, it is typical for a majority of its capital to be invested in equities.
But investment bonds are also a crucial component to a portfolio whose importance and qualities should not be overlooked. Bonds are ‘fixed income’ investments, which means that under normal conditions they return a pre-defined return on investment. When an investor buys a bond, they are, unlike when they buy company shares, not acquiring an ownership interest in the issuer. Instead, they are acquiring debt it issues.
A bond is a way for different entities, from national governments, and large corporations, to smaller companies, to raise capital in the form of debt. Investors replace the role of a corporate lender like a bank by offering up their own money. In return, like a bank, they receive an interest payment against their capital. That interest rate is referred to as a ‘coupon’. However, unlike when a loan is taken from a bank, a bond issuer does not make regular repayments on the initial capital sum.
The bond holder receives only the coupon at regular, pre-defined intervals, which are usually quarterly, bi-annually, tri-annually or annually. The initial capital is returned when the bond ‘matures’. The maturation date is also pre-defined when the bond is invested in and can be anything between a couple of years up to 20 or even more. There are even some bonds, like one class of Treasuries issued by the UK government, that have no maturation date and are rolling. The government can however, should it wish to reduce its overall debt levels, choose to repay the original capital and close the bond, after a fixed period of time has elapsed. Unless that decision has taken the bond rolls indefinitely, with the holder receiving the agreed upon coupon.
The ‘fixed income’ nature of bonds, and the fact they are debt rather than equity, is what set them apart from company shares. When an investor buys company shares, they come with absolutely no guarantees around an eventual return on investment. An investor in shares, regardless of whether they are purchased directly or through a fund that holds a mix of shares from numerous different companies, is making an educated guess that the company will perform well in the future. If it does, and its revenues grow, then other investors should be willing to pay more for the same shares in the future. So a return on investment is realised by selling those same shares for more than the price at which they were purchased as an investment.
The other way shares can provide a return on investment is through dividends – a share of profits. Not all companies pay dividends, or not always, as they prefer to reinvest profits in further growth to keep revenues growing. But when and if they do, shareholders benefit.
But because there is no certainty that a company’s share price will rise, it could also fall if it does less well in the future, or that it will choose to pay out dividends, there is nothing ‘fixed’ about an investment in shares. The return on investment that may be realised is completely dependent upon the company’s performance and the decisions of its board and upper management.
Fixed Income Doesn’t Mean Bonds Carry No Investment Risk
It is important for investors not to make the mistake of equating fixed income assets like investment bonds as investments that carry no risk. Like equities, bonds are still a risk-based investment – it’s just a different kind of risk that they carry.
When investing in equities, the risk is that the company’s share price falls or dividends paid out prove to be poorer than anticipated – which would also be expected to influence share price negatively as lower dividends will reduce investor demand. Share price drops can be sudden if new information comes to light. But more commonly, shares trend down, or up, over a period of time. That gives investors the opportunity to consider at what point to cut their losses or take a profit as their shares loose or gain value.
Bonds are more of a zero-sum game. If everything goes to plan, a holder of investment bonds will receive their coupon returns at the agreed upon regular intervals. And they will be refunded their original investment capital when the bond matures. In that sense, the return on investment (ROI) is ‘fixed’.
The risk is that the bond’s issuer defaults because it doesn’t have the cash flow to service the bonds it has issued. That doesn’t happen very often, especially in the case of bonds issued by entities with a strong credit rating, but it does happen. Just as a when a bank issues loans, it is inevitable that a minority of borrowers will default.
Banks build that into their business model by capping the number of higher risk loans they issue. Or at least, that’s in theory how a bank manages its risk exposure. There have been times when banks, caught up in the euphoria of an economic boom, have issued too many higher risk loans. When the economic cycle has turned that has come back to bite banks. A perfect example is the number of high risk mortgages issued in the USA, and to a lesser extent also in the UK, in the years running up to the international financial crisis a decade ago.
At one point the number of ‘bad loans’, loans the borrowers defaulted on, increased to the point that it tipped banks that hadn’t been careful into a loss. The interest gained on good loans became less than the losses sustained on bad loans.
Investment bonds should be considered in the same way. Higher risk bonds, those issued by entities with a lower credit rating, tend to offer higher coupons. That’s necessary to tempt investors into taking on a higher level of risk. And for investors, putting money into higher risk bonds is what can drive returns as low risk bonds tend to offer coupons that are either only slightly ahead of the inflation rate or even below it. But if investors over expose themselves to higher risk bonds in the chase for higher returns, a change in the economic climate could suddenly see a spike in defaults.
The lesson is that risk should be spread over a diversified and balanced range of bonds. That will mean the impact of any single or small number of defaults can be absorbed by the overall strength of a fixed income portfolio.
The good news is bond issuers tend to default on their obligations to holders as a last resort because doing so, if they survive, will see their credit rating severely reduced. That will make it very difficult for them to access finance, either through bond issues or from a traditional lender such as a bank, in the future.
So what are the default rates on bonds? S&P’s data shows that over the last 32 years, the default rate for investment grade bonds has been a very low 0.1% per year. For high yield bonds, those issued by companies with a credit rating below BBB, it is 4.22%. However, for the lowest rated issuers, those with a CCC/C rating, the default rate leaps to 26.85%. The last number is heavily influenced by defaults during periods of economic recession.
Why Invest In Bonds?
Despite the fact that fixed income bond investments are not risk-free investments, and that, historically, investing in equities has offered better long term returns, they are still a cornerstone to classically diversified investment portfolios. That’s because they perform a role that goes beyond simply offering investment returns. They also provide an investment portfolio with crucial diversification from equities because the two asset classes show low correlation.
When financial markets are going well, equities would be expected to outperform the returns generated by investment bonds. But, during economic downturns or crashes, stock markets typically plummet. That usually sees equities investors sustain heavy losses over such periods. And while stock markets, as a whole, have historically recovered from bear markets, it can take a number of years before they return to, and hopefully then surpass, their pre-crash levels.
That’s not necessarily something for long term investors to lose sleep over. In fact, stock market crashes are when the best equities returns can be made. Or at least, if that’s the point at which you invest, ahead of a recovery.
So why are bonds such an important component to an investment portfolio? Investment bonds bring a number of qualities that nicely compliment equity investments. The first is that the returns on an investment in bonds are not correlated to the stock market. Unless the bond issuer gets into serious financial trouble and is unable to honour their debt while the stock market is down, then bond investments should not suffer while stock markets slump. In fact, exchange traded bonds almost always rise in value as more investors seek refuge in fixed income investments.
The lack of correlation between bond returns and the stock market is important for a couple of reasons. The first is that when part of an investment portfolio’s capital is in bonds, the portfolio’s overall value will fall less during a stock market downturn. That reduces volatility. And lower volatility has been proven to improve long term returns, even when average annual returns work out the same between more and less volatile investments. That’s due to the power of compounded returns – reinvesting returns back into the portfolio rather than taking them out as cash. Because the bonds will keep on earning returns during down months and years for the stock market, it doesn’t completely miss out on the compound effect over that period.
The second reason is that one of the fastest ways to devastate the value of an investment portfolio is to sell equity investments during a stock market downturn – especially if it’s a severe one. Long term investors will simply wait for the market to recover. But the problem arises if an investor needs to cash out investments during a bear market – solidifying paper losses. That could be because the investor already relies on drawing an income from their investment portfolio or has an unexpected expense they need to cover and their investments are the only option to fund that. Shares then have to be sold while their values are depressed.
But an investor that holds bonds doesn’t have that problem. The bonds will, in most cases, hold their value and can be sold if exchange traded. So short term drawdowns can be made by cashing in bond holdings, not equities – allowing the latter time to recover their value when a bull market again takes hold. A more aggressive investor could even cash in part of their investment bonds holding while the stock market is depressed and use that cash to invest in more equities at bargain prices, subsequently rebuying the bonds having made, if all goes well, some tidy returns. Stock market returns are typically best immediately following a bear market. The worse the stock market crash, the stronger the recovery usually is over the first months and years it returns to an upwards trajectory.
How Much Of An Portfolio Should Be Allocated To Investment Bonds?
There’s no black and white answer to that question and it is also very much influenced by an individual investor’s aims, personal financial situation and where their portfolio is in its lifecycle.
For younger investors still in the early years of building an investment portfolio and with many ahead of them before they plan to draw cash down from it, the allocation to bonds in a portfolio, especially lower risk bonds, would usually be low. Somewhere between 10% and 30% depending on how focused the investor is on either growth or value preservation. More conservative investors might decide to allocate up to 20% or 30% to bonds while those who want to drive shorter term returns would be expected to stay at the lower end of that scale.
However, as an investor inches closer towards the time they plan to start drawing down an income or lump sums from their investments nest egg, the typical approach would be to start gradually increasing the allocation to investment bonds. That’s because they would have less time to ride out any stock market slump and wait patiently for a recovery before selling off equity holdings. A larger bond buffer would head off that risk as bonds, which wouldn’t be expected to have lost value, could be cashed in instead.
Investment Bonds – UK Options
UK investors have a good range of choice when it comes to the kind of bonds they can choose to invest in. They also come with wide range of risk to reward profiles. The main kinds of investment bonds are:
Gilts: issued by the UK government, Gilts are among the lowest risk kind of bonds it’s possible to invest in. The only risk is that of the UK government defaulting – something that has never happened and would be a very surprising turn of events indeed at any point in the foreseeable future. However, the flip side to the low risk profile is that Treasuries tend to offer a low coupon, that usually even runs below the inflation rate.
Treasuries and Other International Government Bonds: Treasuries are bonds issued by the USA’s Federal Reserve and are very similar to domestic Gilts. As another government with a very good credit rating, Treasuries also tend to offer a modest coupon but do provide a nice way for investors to diversify currency risk. If the value of the pound were to drop against the dollar over the period an investor holds a bond, they could make a nice bonus return when the capital invested, plus the interest received over the Treasury’s lifetime, is converted back into pound sterling. Of course, the other possibility is the pound rising against the dollar, which would have the opposite effect.
Investors could even invest in other international bonds such as German bunds, for euro exposure. It’s also possible to invest in bonds issued by governments from countries that are less politically and economically stable. Because the issuing country will have a poorer credit rating, these bonds typically offer higher returns. But it should be kept in mind that while national governments rarely default on their bond obligations, it does happen. Argentina has done so twice by declaring itself bankrupt.
Investment Grade Corporate Bonds
These are bonds issued by large, blue chip companies that have a strong credit rating. They tend to, though not always, pay a higher coupon than major government bonds and are also relatively low risk.
Another kind of bond issued by large companies, though sometimes not as large as the blue chips that sell investment grade corporate bonds. The difference is that the companies that issue bonds categorised as ‘junk’ have a lower credit rating. Here, it is important to differentiate between the varying degrees of ‘lower credit rating’. Junk bond issuers at the high end of the credit rating scale also relatively rarely default. At the lower end of the scale, it is not particularly unusual for junk bond operators with the worst credit ratings to default. Junk bonds can offer very attractive coupons but investors should be aware that comes with a higher risk level and diversify well so one issuer defaulting on bonds they own won’t have a huge negative impact on their overall portfolio.
Minibonds are the riskiest kind of bonds. They also usually pay the highest coupons to attract adventurous investors ready to take on risk if the rewards are high enough. The FCA has recently issued a 12-month ban on their promotion to retail investors as a result of concerns many are attracted by the high ticket returns without appreciating they are high risk investments – perceiving them to be as secure as investment grade bonds.
It is important to stress that there is nothing inherently wrong with minibonds as an investment class – if the investor appreciates their risk profile and diversifies it among a number and other kinds of investments, whether low risk bonds or equities. Minibonds can still be promoted to sophisticated investors and high net worth individuals. Smartly invested in, balancing risk, they can be an effective way to drive portfolio returns.