2. Long term savings - the opportunities and risks - Bonds (part 1)

Tuesday, 10th May 2016 09:14 - by David Harbage

This is the second in a series of articles assessing the merits and shortcomings of the prime asset types that private individuals will consider when thinking about their pension, or other long term investment, planning.

Having considered the ‘pros and cons’ of cash, we start to look beyond – ever mindful of the risks of disappointment, as well as the prospect of higher returns – to fixed income or bond investments.

Now a bond can mean a multitude of different things, from a simple long term interest rate to obscure structures which have more twists and turns than a character of Ian Fleming’s invention. In this article, our focus is on quasi-cash assets; by-passing bank, building society or National Savings accounts which feature incremental interest in exchange for imposing a set date for repaying (also known as redeeming) the capital, or notice periods for withdrawals (i.e. denying immediate access to such monies). We may return to more complex bond investments at a later date but, if in doubt about the nature of a financial product described as a bond, one should look beyond the wrapper to the underlying investments (for example many insurance-linked managed bonds are invested in ordinary stocks and shares).

A bond can be regarded as an IOU, a note in which the issuer (usually a government, bank or other company) borrows money from investors (typically institutions, but also private individuals), promises to pay a fixed rate of interest (such income, usually paid half yearly or annually, is often referred to as a coupon) and return the monies (sometimes described as the capital or principle) on a certain future date. Borrowing at a fixed rate of interest over the longer term suits both governments and corporate entities – knowing they will have undisturbed use of such money, with certainty of how much it will cost – and, accordingly, the bond issuer is prepared to pay a premium rate of interest (usually above the returns available on overnight cash). The magnitude of that premium will depend on the quality of the bond’s issuer – essentially the reliability (as assessed by credit rating agencies, perceived by investors and reflected in the market valuation), of safely receiving the promised income and the eventual return of capital – and the length of time that monies are being lent for.

In the universe of UK issued sterling bonds priced and traded on the London stock exchange, HM Government offers the highest possible quality (rated AAA by Standard & Poor’s, AA+ by Fitch and Aa1 by Moody’s credit analysts). The interest rates offered on such government bonds (colloquially termed ‘gilts’) are regarded by academics as the ‘risk-free rate of return’, and form another critical benchmark by which the success of investing money can be assessed. For example, the current interest rate offered on a bond backed by the UK government with a life of 10 years is 1.5% per annum, which is based on a presumption that the gilt would be held to maturity. As with the Bank rate of 0.5%, the 10 year gilt’s return is calculated before any deduction of tax, and the 1.5% is best described as the gross yield to redemption (GRY). While a conventional bond’s income and capital returns are fixed, its yield will alter - because yield is a reflection of the asset’s price – which will fluctuate as gilts are bought and sold on a daily basis.

Almost every other issuer will have to offer higher coupons than gilts; essentially to reward, or compensate, investors for accepting the higher risk of potential default on the obligation to service the debt (pay the interest, and return the capital). By contrast with the 10 year gilt, bonds issued by giant multinational businesses with strong balance sheets may offer investors a GRY of 3%, whereas a small domestic company might have to pay 6% to attract money in the bond (sometimes termed the debt) market. The prospect of higher returns is necessarily offset or accompanied by an increased risk that income payments or eventual redemption monies are not delivered. Credit agencies endeavour to assess the quality of issuer, and importantly the finer detail (for example any special covenant surrounding the security of bondholders’ claims should the issuer become bankrupt), before placing a rating or score on each individual bond. Beyond UK gilts’ AAA, which is not shared by many governments (US bonds are rated AA+ by Standard & Poor’s), the investment grade rating for companies is a minimum of BBB, before moving lower into what is commonly termed ‘junk’ status’.

Further information on gilts can be found from the UK Debt Management Office’s website. Beyond conventional gilts and corporate bonds, as described above, there is a wider range of bond assets that may interest personal investors. In particular, inflation-linked issues offer the opportunity to insulate oneself from the impact of high inflation, which can erode the purchasing power of capital, by owning gilts or corporate bonds whose returns – both income and on the redemption of capital – are linked to an index of domestic inflation, such as the Retail Price index (RPI) or the Consumer Price index (CPI). Capital gain made on UK government stocks are free of tax, and the low income coupon (enhanced by inflation) offered by index-linked gilts means that potentially much of the total returns will come via tax-free capital appreciation - a major benefit to personal tax payers, although the overall gilt market is dominated by (and is therefore priced for) gross institutions who will be tax agnostic. Such bonds can compliment inflation-linked National Savings certificates, but offer the benefit of having their worth priced on a daily basis by the stock market. The UK government bond market is more efficient (and likely to reflect fair value) than most security markets, by which we mean that gilt prices reflect the heavyweight nature of buyers and sellers (owners and potential owners, both at home and overseas, dominated by pension funds and other big institutions) who have a good understanding of the likely path of future interest rates and of inflation.

Private investors should consider bonds from the perspective of their personal circumstances (notably income required), appetite for risk (think about the prospect of non-delivery of returns), the investment alternatives (more of those to be discussed in future articles) and expectation of where interest rates are likely to be in coming months and years. No one doubts that bonds can provide additional income over current overnight cash rates or be an inflation hedge, but very low short and medium term interest rates can only rise from current levels - taking a medium term perspective. There is a real prospect that gilts – which currently enjoy ‘safe haven’ appeal, as well as artificial demand from the Bank of England’s (Quantitative Easing policy) purchases – will lose their shine, looking further out over the next 3-5 years.

David Harbage

26 February 2016

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.