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Pros and cons of fixed income

This article is part of
Guide to Fixed Income Funds

Investing in bonds alongside other assets brings diversification benefits to a portfolio, according to John Pattullo, head of retail fixed income at Henderson. He says his view is based on the premise that competing asset classes tend to rise and fall, in response to different factors.

Mr Pattullo says: “A bond’s capital value or income is likely to fall or rise, at different times to those from the other investments in the portfolio.

“Diversification works when the performances of the investments in the portfolio have weak relationships with each other - i.e. they are ‘uncorrelated’. Equities, bonds, property and cash are the starting points for any basic, diversified investment portfolio.’’

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Mr Pattullo warns that while the coupon on a bond is typically fixed and known, the nature of the way they are traded means investing offers no guarantees as to future returns and the value of a bond and income may go up and down.

Mr Pattullo says: “Bonds are rarely held from issuance to maturity by the same investor. Instead they are regularly traded during their lives on bond markets, changing hands between willing buyers and sellers.

“This means that the investor experience may vary widely in terms of the direction of prices and also the income.

“Defaults can occur when the issuer fails to pay back on the pre-agreed due date. Default risk and how far the level of coupon payments compensate for this risk, are the primary concern of bond investors.”

There are many complex aspects of bond investing, Mr Pattullo warns, and bond markets continually evolve.

He says: “That is why professional investors are the main market participants in many countries, buying and selling bonds on behalf of funds and clients.”

Ultimately, though, fixed income securities generally are among the safest forms of investment after cash deposits, according to Trevor Welsh, head of UK sovereign and inflation at Aviva Investors.

Mr Welsh says fixed income securities are safer than most forms of investment because unlike equities and other riskier assets, they pay investors stable cash flows.

Unlike, for example, equity income that is based on what are essentially discretionary dividends, the only barrier to the regular income being paid is a default of the company or government - a rare event. And in the case of default, Mr Welsh says the vast majority of bondholders rank senior to equity investors.

Furthermore, Mr Welsh says investors can choose to lend to the most highly-rated borrowers such as governments and supranational institutions, albeit for lower returns.

Bonds are, however, susceptible to inflation eroding the value of the fixed income, though Mr Welsh says there are some bonds available which are ‘inflation protected’. He adds that bonds can protect against interest rate rises, as investor can back bonds with shorter-dated maturities.

One particular aspect of the diversification offered by bonds, Mr Welsh says, is that bonds tend to do better in bad economic times, but conversely offer comparatively less stellar returns when the economic backdrop is more positive.