Providing significant value in a diversified investment portfolio
Fixed-income investments, often called bonds, offer a unique blend of benefits that can provide significant value in a diversified investment portfolio. They strike a balance between shares and cash regarding risk and return, offering a steady income stream. These are long-term investments sensitive to inflation and interest rates, with the possibility of capital loss.
Bonds are debts of various entities, from corporations to governments. They promise a fixed annual income, or coupon, and return the original capital at the end of a specific term. This asset class is particularly attractive to investors willing to take on a bit of risk for returns higher than cash.
Risk, return, and yield in bond investments
The income potential of bonds is highly dependent on the issuer’s risk profile. Riskier entities, be they companies or countries, offer a higher coupon to entice investors. Meanwhile, low-risk issuers can afford to issue lower-yielding debt in line with general inflation or interest rate expectations, reflecting a minimal risk of default.
A bond’s ‘yield’, the ratio of its annual income to its price, is a crucial measurement for investors. For example, a bond priced at 100p with a yearly income 6p yields 6%. It’s important not to confuse this yield with the interest rates on cash, as a bond’s value can decrease, and its capital and income are not guaranteed.
Balancing risk and return with fixed-income investments
Although most fixed-income investments carry less risk than equities, they offer a lower potential upside and typically do not provide a growing income. However, their lower volatility and consistent income make them an attractive option for balancing an income portfolio. Some extremely cautious investors may even opt for a higher allocation to bonds than equities. It’s worth noting that bonds and equities don’t usually move in sync over long periods, though they can over shorter periods.
Exploring individual bonds
Investing in individual bonds is an option for investors, with most promising to repay the invested money at a specific ‘maturity’ date. Meanwhile, investors receive a periodic ‘coupon’ or interest payment. However, investing in individual bonds carries risks – if the bond issuer faces financial difficulties, it may ‘default’ on income payments and/or capital repayment. The value of the coupon depends on the bond issuer, making it risky to invest a substantial amount of money in an individual bond.
Government bonds (like UK gilts) usually offer low-interest levels as they are considered to have low ‘credit risk’. However, these are susceptible to inflation and interest rate changes, and their capital value can fluctuate. On the other hand, corporate bonds offer higher coupons, especially those from riskier businesses, reflecting the firm’s creditworthiness.
Understanding bonds’ finite life
Bonds typically have a finite life, meaning they are usually paid back at their issuance value, although exceptions like ‘perpetual’ debt exist. Throughout their life, individual bonds can be bought and sold like any other investment, and their value can change, which means you might get back less than you invest.
Notably, in the event of bankruptcy, bondholders, as creditors, could receive a proportion of the remaining assets after the company is liquidated. This is a crucial distinction between shares and bonds. In a liquidation scenario, shareholders will likely be last in line to receive any money and could receive nothing.
The convenience of bond funds
Instead of buying individual bonds or gilts, investors can opt for a convenient package of these investments through a ‘fund’. Investing in this manner allows you to spread risk while targeting the asset class generally or a specific segment.
When investing in a fund, such as a ‘unit trust’ or ‘open-ended investment company’ (OEIC), you buy units alongside other investors and collectively invest in a portfolio of assets. Each unit has an individual price called the Net Asset Value (NAV), which is determined by the price of those assets.
Advantages of fixed-income ETFs
Exchange-traded funds (ETFs) allow you to join a collective portfolio of investments, including bonds, gilts, and other fixed interest areas. The main difference is that ETFs can be traded in real-time on a stock exchange, whereas other funds are traded only once daily. They are typically passive investments with low charges, but it’s important to note that costs are associated with dealing in shares.
Higher yield options and their risks
Investors are often drawn to investments that yield a high level of income. However, a high yield can also be a red flag, indicating a greater chance of default and capital loss. There are funds designed to produce high-income levels while aiming to control these risks through diversification.
High-yield bond funds can bring something different to a portfolio. For instance, they are more likely to be resilient in a robust economic environment where company bankruptcies are falling.
THIS ARTICLE DOES NOT CONSTITUTE TAX OR LEGAL ADVICE AND SHOULD NOT BE RELIED UPON AS SUCH.
THE VALUE OF YOUR INVESTMENTS CAN GO DOWN AS WELL AS UP AND YOU MAY GET BACK LESS THAN YOU INVESTED.
THE TAX TREATMENT IS DEPENDENT ON INDIVIDUAL CIRCUMSTANCES AND MAY BE SUBJECT TO CHANGE IN FUTURE. FOR GUIDANCE, SEEK PROFESSIONAL ADVICE.