WE'RE often asked questions from referrers on behalf of their own clients. Without knowing the client, it’s not easy to answer the questions. We have a regulatory requirement to understand an individual’s circumstances, needs and wants, as investment is a longer-term consideration, not a get rich quick endeavor.
Recently, we were asked about an individual who was advised to invest in a range of bonds because they were low risk. The referrer wanted to know if they were suitable.
What is a bond?
Simply it is a loan from you to a company, such as BT, a bank, or if you’re feeling generous, and feel comfortable with them repaying you, the government.
The company agrees to pay you interest (coupon) for the term of the loan before repaying the capital. Like everything, your return comes from the risk you might take. If you lend to a low risk, financially strong company, the coupon will be reasonably low, and vice versa.
There are two questions to ask yourself with regards to the risk: will the company default on the coupon, or will they default on the capital repayment?
Most investors wouldn’t know which companies to invest in, so there is a range of funds available that spread your investment across an array of organisations.
However, there is still a level of risk as the fund could be achieving its performance through investment into higher risk companies, so speaking to an IFA is a good starting point.
When thinking about investments and risk, it’s always worth remembering the words of Warren Buffet.
He said: “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes. Put together a portfolio of companies whose aggregate earnings march upwards over the years, and so will the portfolio’s market value.”
It is also important to keep an eye on interest rates. We’ve had unprecedented low interest rates and we’re loathed to predict when they will rise in the UK, but a bond can be affected by global rates as they relate to the issuing company.
In 2015, the Swiss government issued bonds with less than 0 per cent yield, while the Mexican government issued 100-year bonds with yields of 4.2 per cent. We’re not sure if many investors will keep them to maturity, or if the bonds will be used to pay for Donald Trump’s wall!
When interest rates rise, bond prices generally fall and when interest rates decline, bond prices tend to rise. When rates go up, newly issued bonds come to the market with higher coupons than existing bonds.
Naturally the newly issued bonds are more attractive than the equivalent existing bonds with a lower coupon. So, in order to sell their existing bonds, investors have to reduce their prices to make them equally attractive.
Consider also that interest rates will have a different impact on a bond depending on how long it is due to run before maturity. The prices of longer-term bonds are more sensitive than shorter-term bonds to changing interest rates.
Similarly, fixed income funds with longer average maturities tend to be more sensitive to interest rate changes than funds with shorter average maturities.
So which bonds are most impacted by interest rate rises?
Interestingly government bonds tend to be most impacted because of their high credit quality. Therefore, the lower risk and lower yielding funds become more affected by interest rate movements, especially those with a longer duration, which is almost a contradiction to what you think might happen.
To lower your risk with your investments you would use such instruments as mentioned above but choose an investment fund that can move between all the different bond offerings available, to reduce your risk and maximise your return further.
Our view is be advised by an independent financial adviser on your overall tax efficient and diversified investment portfolio, so you avoid the old ‘eggs in one basket’ adage.
:: Darren McKeever (dmckeever@wwfp.net) is Northern Ireland adviser of Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. For a free, no obligation initial chat about your individual finances, call 028 6863 2692, email info@wwfp.net or click on www.wwfp.net. Follow us on Twitter: @WorldwideFP
