The bond renaissance

As eurobonds took off, the number of bonds on the London market dwindled as they expired, and those bonds that were issued became increasingly the preserve of big pension funds. However, heavy retail demand for fixed-income securities was noted well before the credit crunch began, and the launch of the London Stock Exchange's order book for retail bonds (Orb) in 2010 is due in no small part to a long campaign by a number of City grandees, including Paul Killik of Killik & Co and the Association of Private Client Investment Managers and Stockbrokers.

Since then, the humble bond has rapidly re-established itself in the UK as a tradeable asset class after retail investors regained access to a viable bond market. The subsequent years have seen an increasing wave of issuance, particularly from smaller companies eager to sidestep increasingly onerous terms on conventional bank debt.

This autumn has been a particularly brisk time for Orb, with property companies in particular taking advantage of the lower financing costs associated with bonds to pitch their issues directly to retail investors. That trend is to be welcomed as corporate bonds offer an opportunity to diversify risk without relying on government debt, or potentially expensive bond funds. However, this does mean investors need a different set of analytical tools when it comes to weighing up the risks and opportunities.

Bonds reborn

Readers who have followed the development of Orb will have noted how quickly the market has turned into a funding vehicle for companies with high bank funding costs. This isn’t entirely an accident. The whispered complaint from many chief executive officers (CEOs) is that banks are upping fees for small- and medium-size enterprises; it isn't necessarily the interest rate that is the problem, rather the rising costs of arrangement fees, maintenance fees, non-use fees and all the paraphernalia of bank lending that anyone with a credit card can identify with.

In effectively swapping their credit cards for long-term personal loans, companies are trying to limit the marginal cost of debt. Orb was designed in part to achieve this as firms not only diversify their funding, but arrange loans that are longer than the five-year maximum term that banks will normally agree to.

There is also the increasing pressure on investors to try to find potential sources of income yield in a time of low interest rates and squeezed credit. On the one hand, junk bond issuance is reaching all-time highs as companies try to lock in some of the lowest rates for the asset class anyone can recall. Average yields on non-investment-grade debt have fallen to just 7.4 per cent, with investment-grade bonds yielding below 4 per cent for the first time, according to Thomson Reuters data.

Who's raising what

The autumn has been a busy period for the issue of new bonds. Even Cambridge University gained a coveted AAA credit rating earlier this year and issued a £350m bond paying a coupon of 65 basis points above the equivalent 4.25 per cent gilt, although it is not available on ORB. The university plans to use the new funds to update student and staff accommodation at two locations in the city.

The Orb market has maintained a particularly brisk pace of issuance since the end of August. Property companies such as Primary Health Properties, CLS, Workspace and most recently St Modwen have all taken the opportunity to raise money directly from the private investor.

Stephen Wilmot, the IC's property correspondent, has already noted that the risk profile of companies issuing bonds has steadily increased, with property management companies giving way to pure real estate development companies with less recurring revenue. The diversity of companies listing bonds should be welcomed, but some market observers fear that Orb could go the way of the Alternative Investment Market (Aim) and become a funding wheeze for undercapitalised small companies.

That could conceivably happen, particularly if larger firms decide that the amounts they can raise through retail bonds cannot match their much greater funding needs. What is needed in the short term is a kick-start from a particularly large issue. This could come from the London Stock Exchange, which itself launched its first retail-focused bond on Orb with a 4.75 per cent bond issue of £300m.

And while the absolute amounts that large companies have raised on Orb may not be huge in terms of their total financing needs, retail bonds can actually make up a significant proportion of refinancing in an individual year; Severn Trent's £75m offering launched earlier this year will take care of about a quarter of its requirements for 2013, for example.

In addition, bond issues are an increasingly important source of revenue for brokerages at a time when initial public offerings are scarce; a bond runner and builder will take about 1 per cent in fees from the total issue, which is a lot less than equivalent equity issues for companies, which obviously is another incentive to raise debt.

Other ways to access bond markets

Orb has made buying individual bonds much easier, but the plain fact is that many investors will still access the bond markets via a wide range of open-ended investment funds and ETFs. Invesco and M&G both have respected bond funds managed by well-known managers such as Richard Woolnough, and iShares has a number of ETFs that track the value of otherwise difficult to access bond markets, for example index-linked gilts.

The main disadvantage of funds is the perennial problem investors have with fees. These can eat up to 1 percentage point of your annual returns and are charged regardless of the overall performance. Secondly, you have no control over what a fund holds, meaning investors could end up exposed to sectors or types of credit that they would never willingly choose on their own account. What is needed is a way of understanding how to manage a portfolio, so to this end we have pieced together a model portfolio and strategy that retail investors can use.

Model ladder portfolio

Building a model portfolio

The main problem for retail investors who want to take an active approach to buying bonds is choosing a strategy. Bond investing lends itself naturally to building a portfolio because, unlike share prices, which tend to be correlated with the general direction of the market, the price movements for bonds depend much more on the quality of the underlying credit. Bond prices often have an inverse reaction to the equivalent share prices depending on how risk-averse investors become.

Mark Glowrey, head of fixed-income sales at Canaccord Genuity and long-time bond market commentator, believes that the ORB market is now broadening out enough in terms of sectors and quality of credit to allow investors to follow an effective diversification strategy. However, there are some fundamental problems to overcome: "The first thing to remember is that the bond market is naturally overweight towards the financial sector. Secondly, picking a bond from the pharmaceutical sector, the engineering and the technology sector is not really diversification.

"What matters is the underlying credit quality. If all these bonds are rated BBB, for example, then their pricing will react in a similar way. The key to successful diversification is to spread risk across different types of credit from investment-grade to junk," he says.

The ultimate goal of any bond portfolio is to reduce volatility. The table above shows a selection of bonds that reflects the type of portfolio that can be built from bonds available to retail investors and, with one or two exceptions, are generally long enough to be included within a self-invested personal pension (Sipp) or individual savings accounts (Isa). The model portfolio shows a spread of credit quality and combines income yield with the possibility of capital growth.

This type of portfolio is commonly described as a 'ladder portfolio' as the date range of the bonds means that 10 per cent of your capital will be redeemed every year. This highlights another important aspect to bond investing; keep on top of inflation and interest rate risk by reinvesting every year in the market, as in this way you smooth out the natural fluctuations in interest rates over a given time. Inflation can be countered with the inclusion of index-linked bonds and by coupons on new bonds that start to reflect higher inflation or interest rates. In short, always keep a finger on the pulse of the market.

The portfolio tries to avoid the natural bias towards financial services inherent in the bond market, but inevitably financial services companies will make up a majority of available bonds. Overall, the ladder portfolio generates an average yield of 5.9 per cent at an average cost of 108p.

That's pretty good compared with the income yield on shares, although equity investors don't worry as much about inflation. What it does illustrate is that it is possible to smooth out capital costs and guarantee decent income without taking too much downside risk on sub-investment-grade debt.

The end-game for gilts

What some investors may question is the absence of gilts as these are a key component of portfolio management, particularly in the way they offset riskier assets classes. We made the conscious decision to exclude gilts from the ladder portfolio because, over the 10-year time-frame, current high prices for 10-year gilts would drag down the potential income yield. Indeed, many investors are now accepting negative real yields in return for the UK government's absolute guarantee of payment.

In many ways, it is hardly surprising that gilts have surged and the main customer is the Bank of England, which has piled them onto its balance sheet. By contrast, it may make sense to simply hold cash in preference to gilts as deposit rates have been picking up as banks compete for business.

IC bond tips: How did we do?

We have tipped a number of bonds over the years, generally in the 'Bond of the Week' column provided by the experts at Stockcube. The table below lists the bonds tipped over the past three years, along with a comparison of their current prices and yield performance. As you can see, investors enjoyed decent yield and capital appreciation from almost all the bonds highlighted, although there has to be some leeway because of the statistical difference between prices gathered over three years and a current snapshot.

The relative stability of income yield is interesting, suggesting that investors can still obtain income if they are prepared to pay higher prices. Also, unlike dividends, the basic payout on a coupon doesn’t change, making a direct comparison slightly easier. Values have increased generally as risk appetite has returned and pushed previously unloved assets, such as bank bonds, back over par. The squeeze on yield has been general and not confined to single or credit class.

Investors Chronicle bond tips