Weighing up direct investment in bonds
In the context of the current volatility, inflation-linked bond yields are a good choice
Even as a bubble inflates in gilts, the UK’s retail corporate bond market is widening.
Severn Trent, the water utility, recently launched an inflation-linked bond aimed at the retail market. Icap, the money broker, is offering a six-year bond paying 5.5 per cent a year. Tesco and National Grid have also appealed to retail bond investors.
The risk/reward trade-off for corporate bonds is quite different from that of equities
This is the way things used to be. Private investors used to be active in the corporate bond market, supplementing their income with a bit of extra yield compared with deposits and government bonds. Their enthusiasm for fixed income was destroyed by the inflation of the 1960s and 1970s. Ever since, there has been a strong bias towards stocks.
The revival of enthusiasm for direct investment in corporate bonds comes at a time when the yield on 10-year government bonds is at a record low and even the most assiduous “rate tarts” are lucky to get 3 per cent interest on their savings.
At the same time, the baby boomers are gradually retiring and are being forced to supplement their meagre state pension with savings income. Annuity rates are low by historic standards and, of course, lock up the retiree’s income for the rest of his or her life.
In the recent past, investors have turned to corporate bond funds. These can offer the retail investor a broadly diversified portfolio, in terms of borrowers and dates at which the debt matures. But at a time of low yields in general, the fees and charges on the funds do take a fair-sized chunk out of the investor’s income. Total annual expenses are around 1.4 per cent for one of the most popular, M&G Strategic Corporate Bond, and 1.2 per cent for Invesco Perpetual Corporate Bond, one of its rivals. The obvious danger of direct investment in corporate bonds is the specific risk that an issuer goes bust. The risk/reward trade-off for corporate bonds is quite different from that of equities. Whereas shareholders may all dream of owning the next Microsoft, and multiplying their holding manyfold, the best that corporate bondholders can manage is to get paid back at par.
However, bondholders do have a prior claim on a company’s cashflows, relative to shareholders. If a company gets into temporary trouble, the shares may plunge and the dividend may be cut, but bond interest will be paid. And most issuers to date have been household names. It is hard to imagine Tesco going bust in the near future.
As the market develops, the quality of names may decline a bit, but the trade-off is that it will become possible for investors to obtain a broadly diversified portfolio. Clearly, this will best suit the better-off retail investor. One can imagine a portfolio of 12 holdings in corporate bonds of £5,000 apiece making up 20 per cent of a £300,000 portfolio.