Bonds: one way to shake and stir your investments

PERSONAL FINANCE:Government bonds have become an attractive option for investors, but how do you go about buying them and what are the risks, asks FIONA REDDAN

IF YOU feel ill at the thought of how much the State is borrowing to stabilise the public finances, you might consider investing some of your money in Irish Government bonds.

Due to the parlous state of the economy, the Government is paying high costs to borrow money and is therefore offering a coupon, or interest rate, on its bonds of up to almost 6 per cent.

Considering that the best return in Government-guaranteed deposit accounts is far less than this, government bonds have begun to look increasingly attractive – but how do you go about buying them and what are the risks?

During the boom years, Ireland was an infrequent borrower in global markets, but since the collapse in the property market and near-collapse of the banks, the State has started to borrow actively once more. It has raised almost €23 billion in debt so far this year, with plans to issue another €2 billion later in the year.

This means the debt burden is expected to rise to as high as 73 per cent of national income by the end of 2010. While this is a significant increase on the 25 per cent low reached in 2006, it is still some way from the highs of 130 per cent in the late 1980s.

Nevertheless, the perception of Ireland in the markets has been hit badly by the State’s deteriorating public finances. This has had a knock-on effect on bond prices, with investors fearing a replication of the situation in Iceland.

Last March the difference in yield (interest), or the spread, between 10-year Irish bonds and benchmark German bunds, a critical determinant in performance, peaked at 284 basis points (2.84 percentage points). This was widest difference since the introduction of the euro in 1999.

Since then, things have started to improve slowly. Last month, Michael Somers, the man in charge of the State’s mountain of debt as chief executive of the National Treasury Management Agency (NTMA), noted that there had been a “huge change” in sentiment towards Ireland, illustrated by the improving performance of Irish Government bonds. The difference in spread between Irish and German bonds has since declined to fewer than 100 basis points and Irish bonds are some of the best performers in Europe.

As such, many retail investors are returning to government bonds, once an unpopular choice due to their comparatively low returns compared to equities.

With European interest rates on the floor and decent rates on deposit accounts difficult to find, government bonds are more attractive, with average coupons of about 4 per cent and a recent 10-year issue offering 5.9 per cent.

Liam Clarke, director of institutional bonds with Dolmen Stockbrokers, says Irish Government bonds offer a good alternative to deposits. He has noticed an increase in demand from private clients seeking to place about €50,000 in the bonds.

On a practical level, brokers say investors would need to allocate about €10,000 at least to make a transaction worthwhile.

By investing in the bonds, you are effectively lending the Government money for a specified time.

In return, the Government will make regular interest payments and return the initial capital at the end of the agreed period.

The main advantage of government bonds – particularly in the days before Government-guaranteed deposits – is the security they offer. Unlike corporate bonds, government bonds are considered to be of the highest credit quality and are not subject to credit ratings. If you hold a bond until maturity, the main risk is that the Government can no longer afford to make the interest payments or repay the capital and you lose your money.

Bonds also provide a fixed source of income – something that is not guaranteed with equities, as evidenced by the number of companies that have slashed dividends since the financial crisis began.

So how do you go about buying government bonds?

Firstly, you need to know what you are buying. If new to bonds, the terminology can be off-putting. For example, one of the Government’s recent issues is the 4.6 per cent 2016 benchmark bond. What does this mean?

The percentage – 4.6 per cent in this case – is the coupon, which is the annual interest rate the Government will pay you. The year – 2016 – refers to the maturity of the bond and indicates that the Government will repay the capital then, in this case on April 18th, 2016.

Irish Government bonds are confined to a limited number of fixed-rate benchmark bonds in key maturities, which are close to two, six, nine and 13 years in maturity.

So, for every €100 of the bond held, the Government will pay €4.60 each year from April 18th, 2009, until April 18th, 2016. On that date, the €100 is repaid.

The NTMA sells new issues either by auction or syndication.

By buying a bond at “par” value, you can benefit most from any potential upside. But unfortunately for most retail investors, buying government bonds in the primary market is not an option unless you have a couple of million euro to invest. One possibility, says Clarke, is to put together a syndicate of, say, 100 investors with €20,000 each to invest.

Otherwise, retail investors can make an order in the secondary market through a broker and pay the market price, which will depend on factors including the time to maturity, market interest rates, the credit quality of the issuer and liquidity. The more secure the bond, the higher the price is likely to be.

Another option for investors is to allocate some money to a government bond fund. New Ireland has two funds invested in the 4.6 per cent 2016 bond and in the 4 per cent 2014 bond. Similarly, Eagle Star offers a fund investing in the 2016 Government bond. Generally, all coupons paid on the bond are reinvested in the fund.

While many investors may be content to hold the bond until maturity, the existence of a secondary market means bonds are a liquid asset and you can dispose of them at any time. If you do, however, the price may have fallen. As Clarke notes, the risk with Irish Government bonds is that the public finances may worsen further and the price may fall.

Another possible downside is that the price of bonds tends to move inversely to interest rates so if rates start to rise again, the price of bonds will fall and inflation will hurt returns. However, while the expectation is that interest rates will start to rise in the EU next year, Japan has kept its interest rates below 1 per cent for about 15 years. Just because interest rates are low does not mean that an increase is inevitable.

If, on the other hand, deflation becomes a reality, bonds will become even more attractive, with the real returns on offer in excess of the coupon.

It should also be noted that while returns may appear to be better than those on offer in a simple deposit account, government bonds are less tax efficient, thereby reducing possible gains.

While Irish residents do not have to pay capital gains tax on profits arising from the disposal or redemption of a bond, they must pay tax on the interest element at their marginal rate of income tax.

Although the rate of deposit interest retention tax (Dirt) charged on deposits has risen by a quarter over the past year to 25 per cent, for those paying income tax at 41 per cent, the charge on government bonds is still much higher than that imposed on deposit accounts.

Finally, investing in bonds can be expensive, considerably more so than a deposit account, which incurs no fees or charges.

The lowdown on buying government bonds . . .

Government bonds are sold through stockbrokers and costs differ from broker to broker.

According to a recent survey by the National Treasury Management Agency, Dolmen Stockbrokers, which has operations in Dublin, Cork and Limerick, offers some of the cheapest costs, at just 0.15 per cent for a transaction, or a minimum of €115. This means the cost of a trade worth €10,000 would be €115. The stockbroker also charges an annual account maintenance fee of €85.05.

The larger stockbrokers are more expensive. They generally charge 0.50 per cent on amounts up to about €100,000 and 0.25 per cent on the remainder.

For smaller trades, Merrion stockbrokers is the most expensive firm in the Irish retail market. On a trade of €5,000, for example, the broker charges €250, compared to €100 at Goodbody and Davy.

For larger amounts, Davy, along with Bloxham stockbrokers, is the most expensive, charging a significant €1,000 fee on a trade of €200,000, compared to just €300 at Dolmen.

Annual account maintenance charges can also bite. Merrion has the highest, at almost €250.

Among the other brokers, the cost ranges from zero at Bloxham to €100 at NCB. On an investment of €10,000, with an interest rate of 4 per cent, such charges will eat away at your annual returns, leaving you with just €150 at Merrion and €300 at NCB.