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Whether to invest directly or via collective funds

This article is part of
Guide to Fixed Income Investing

Neil Mayfield, principal at Mayfield Investment Management and chartered financial planner, says the downside to collectives is that there is always the additional charges for using a fund and so the return achieved by the manager must be high enough to justify this.

Plus, a client holding gilts directly would not be subject to any capital gains tax for these investments, so for certain clients this would be an important benefit.

But he believes collectives are generally preferable because:

• funds provide diversification which in turn reduces default risk on corporate bonds;

• the market is complex and a professional manager can draw on knowledge and information not available to an individual;

• funds can provide access to markets not available to the individual investor;

• most funds can be held within ISAs, pensions and other wrappers; and

• a unit trust/OEIC provides liquidity for the investor.

Kevin Telfer, fixed income product specialist at Kames Capital, adds that due to the very wide range of potential investments with different return and risk profiles, he would always recommend collective funds.

“It is very rarely sufficient to just select well known companies or companies that some may perceive to be financially strong. The swathe of recent corporate failures on the High Street and in the financial sector has demonstrated the potential folly in such an approach.”

In addition, he argues that it would be too simplistic to stronger companies make better investments in the world of fixed income.

“A strong company will pay a lower interest rate on its borrowings and therefore provide investors will a lower return potential,” he says. “However, a weaker company will pay a higher interest rate, increasing the return potential provided it survives and repays its lenders.”

The timescales involved also add to the complexity, in Mr Telfer’s opinion.

“Bearing in mind that one can be lending to a company for many years, it can be very challenging to analyse a company or government’s borrowings and other financials characteristics to determine what is a suitable investment and whether its characteristics meet your investment needs and tolerance for risk.”

He maintains other benefits from investing in investment funds include investment funds’ access to a wider investment universe as many fixed income investments are only available to large financial institutions.

“Investment funds can experience lower transaction costs when buying and selling investments as a benefit from economies of scale. Due to the combination of the above factors, investment funds typically offer far greater liquidity than investing directly.”

Mr Telfer claims the corporate bonds specifically targeted at direct investors, known as retail bonds, are offered with less attractive terms as “companies take the opportunity of not having to negotiate with professional investment managers to issue retail bonds with lower interest rates or weaker investor protections than would be demanded by investment managers.”