Bonds the safest bet for wary private investors

Bond products provide a fixed income and a useful method of diversification for risk-averse private investors, writes Caroline Madden

Bonds may not set investors' pulses racing in the same way as the thrills and spills of the stock market. And they are unlikely to ever produce the headline-grabbing returns of the property market, where everyone seems to be making a killing.

But nevertheless, the bond market offers unique attractions, particularly for the risk-averse investor for whom peace of mind is paramount.

The whole area of bonds is cloaked in quite a bit of financial jargon - fixed-income securities, gilts, treasuries, debt markets, credit spreads - but the concept of a bond is relatively simple. Essentially, a bond is a form of debt, like an "IOU", issued by governments and large companies to raise finance, and the purchaser of the bond is the lender.

Investors in bonds are entitled to a fixed income, known as a "coupon", up to the maturity date of the bond, and are guaranteed to be repaid their original capital at maturity.

For example, buying the "5 per cent Treasury Bond 2013" Government bond entitles the investor to interest of 5 per cent a year between now and 2013, when the bond matures and the capital investment is repaid.

The risk profile of bonds ranges from rock-solid short-term Government issuances right across the spectrum to junk-rated bonds. The credit rating of a bond, provided by agencies such as Moodys, Fitches and Standard & Poor's, gives an indication of the level of risk associated with it.

Government bonds usually command an "AAA" investment grade - which indicates that the likelihood of repayment is high - whereas "junk bonds" carry a sub-investment grade rating.

With equities historically providing the highest rate of return on investment over the long-term, and property currently offering phenomenal yields, why would an investor allocate even part of their portfolio to bonds? According to Goodbody's private client division, there are three key reasons for considering the bond market.

Firstly, bonds are generally low risk in relation to other asset classes. In addition, bonds provide a fixed-income flow, with interest payments made semi-annually or annually.

For this reason, they may be more suitable for investors who have a set income requirement than perhaps equities, which do not provide the same degree of certainty as dividends are not guaranteed.

Another key attraction of bonds is that they present a useful method of diversification. "[ Bonds] should form a part of any investor's portfolio, as they provide diversification in times of equity turbulence and deliver a solid income stream in excess of cash," advises Tony Morley, head of fixed-income private clients at Davy Stockbrokers.

So an investor with a low appetite for risk, looking for diversification decides to dip their toe into the bond market - how exactly do they go about this? "Contrary to public perception, there is no mystique to investing in bonds," says Morley.

Bonds can be traded through a stockbroker as freely as equities. "For private investors, investing in the bond market may have been difficult in the past; however, this is no longer the case. It is now very easy for private investors to invest in bonds on the same basis as institutional investors," he says.

"The minimum investment for bond purchases is small. It varies from as little as €1 for Government bonds to typically €1,000 for most corporate bonds."

However, David Ryan, head of fixed income with Setanta Asset Management, warns that the "bid-offer" spread - the difference between the buying and selling price on a given day - can represent a significant cost for an individual investor trading in small quantities of bonds and can diminish the attractiveness of such investments.

Investors taking the plunge must firstly decide what proportion of their total assets they wish to allocate to bonds; for example, an 80/20 split between equities and shares. Then within this they must decide on the specific bond allocation. The key consideration when selecting bonds is the individual's target income from the investment. Once this is determined, they can start looking at credit ratings, time to maturity and yields.

Investors with a higher risk preference may consider sub-investment grade bonds, but Goodbodys warns that low-grade bonds are not for all investors, as the higher the yield offered, the greater the risk of the investment.

Known as "high-yielding bonds" in stockbroker speak, these were more commonly called "junk bonds" when they came to prominence in the 1980s on Wall Street. At that time, a lot of large mergers and acquisitions were taking place and in to finance these transactions, companies floated low-quality junk bonds to the public with enticingly high rates of interest attached. But this market eventually imploded, with a huge number of defaults by junk bond issuers.

A category known as "fallen angels" has come to the fore in recent times and has been outperforming junk bonds. Fallen angels are large corporations such as General Motors and Ford Motors whose credit ratings have been downgraded from investment grade after the deterioration of the company's financial strength.

According to Merrill Lynch, fallen angels have returned 8.1 per cent so far this year, compared with a 4.9 per cent return for junk-rated companies.

Many investors choose to access the bond market indirectly through funds rather than investing directly in individual bonds. The investor benefits from fund managers' experience in timing the market and adjusting the allocation of the fund to take advantage of market shifts, which can be more lucrative than the "buy andhold" strategy commonly adopted by individual investors.

While bonds may not set the investment world alight, this slow and steady asset class can provide a comforting safety net for the prudent investor.

Corporate bonds

Corporate bond issuances are few and far between in the Irish market.

In the Republic, and Europe in general, large companies rely more heavily on bank loans for funding, whereas in the US companies are more likely to issue bonds as a means of raising funds.

According to Goodbodys, the more risk-averse individuals typically stick to Government bonds, but those who opt for Irish corporate bonds tend to go for names that they recognise such as Bank of Ireland.

"In our experience, for private investors, bonds issued by corporates such as Independent News & Media, Eircom and the domestic financial institutions, for example, EBS/BOI are the most popular," says Tony Morley of Davy Stockbrokers. "Each bond has a different rating, for example, a recently issued bond by Eircom was sub-investment grade, whereas a recently issued bond by Bank of Ireland Mortgages was AAA rated."

The small number of Irish corporate bonds available means that Irish investors often look overseas for investment opportunities.

"With the advent of the euro, Irish private investors can access a wider universe of European bonds suitable to their needs," says Morley.

Goodbodys have found that, in terms of foreign corporate bonds, Irish investors opt for large financial institutions such as HSBC, RBS and BMP.

Government bonds

Government bonds, known as gilts in the UK and Ireland, and treasuries in the US, are issued to fund government borrowing requirements. They generally offer a fixed rate of interest for a number of years, and have a specific redemption date.

Government bonds tend to be given the highest credit ratings, as the likelihood of governments in stable countries defaulting on the terms of their bonds is negligible. However, they are not always risk-free. For example, the Russian government defaulted on some of its foreign currency bonds in 1998, and similarly the Argentinian government defaulted on bonds in 2001.

The Department of Finance was traditionally responsible for the issuance of gilts in the State, but the National Treasury Management Agency (NTMA) has now taken over this role. As with corporate bonds, gilts are tradeable securities and so can be bought and sold through stockbroking firms between their issue and redemption date.

"The average yield [ of Irish gilts] at the moment is quite low," says Oliver Whelan, a director at the NTMA. He explains that yields are currently running at approximately 3.9 per cent per annum.

Goodbody Stockbrokers commented that in this current low-yield environment, investors are tending to look beyond Government bonds in order to enhance their returns, and this is generating more interest in corporate bonds.

However, David Ryan of Setanta Asset Management, advises that 'credit spreads' - the gap between yields from government bonds and corporate bonds - have narrowed recently, which means that this may not be the best time to invest in corporate bonds.

Investors should weigh up whether the extra yield is sufficient to take on the extra credit risk.

"In our experience, corporate bonds rather than Government bonds are more popular with Irish private investors," says Tony Morley of Davy Stockbrokers. "This is because Irish private investors typically are as comfortable from a credit perspective holding bonds issued by say Bank of Ireland, as those issued by the Government." Gilts are not really aimed at "the small saver", Whelan says, but "very high net worth" individuals might consider them.

He explains that institutional investors own the vast majority of Irish gilts.

According to information published by the Central Bank in July of this year, only 163 million out of a total Government bond issuance of 31.554 billion is owned by "households" or private investors.