So assuming that access continues to get easier and trading cheaper, why should you bother with bonds? The short answer is that they are one of the keys to a properly diversified portfolio. In classic portfolio theory, safe and liquid investments such as gilts should be used to balance off the riskier assets in order to get close to the fabled 'efficient frontier' where returns are matched exactly by the given risk. Portfolio theory took a battering during the credit crunch, when all asset classes displayed an unusual degree of correlation. But in a low interest-rate environment, which the Bank of England recently hinted will continue for some time, the inflation risk for bonds is tempered by the prospect of slow economic growth.
Five key risks to consider
The process of choosing a bond is totally different to that of choosing an equity. We've highlighted five key risks to consider before opting to invest in a bond.
■ Interest rates: when rates rise, bond prices fall and yields (which are the inverse of prices) rise. Because both sources of return on a bond – the 'coupon' it pays and the price at which it is redeemed – are fixed, its attractiveness to investors waxes and wanes with changes in the interest-rate outlook. However, this can also lead to bargains in the secondary market as bonds are always redeemed at par.
■ Inflation: fixed returns are less attractive in an inflationary environment. Short of continually swapping issues for higher-yielding ones, the only real hedge is to hold a significant portion of index-linked gilts, or Treasury notes, as security.
■ Default: the issuer cannot either maintain the interest payments or redeem the issue. This is the main 'idiosyncratic risk' attached to bonds. What normally happens is that the issuer negotiates with the creditors, who agree to write off part of their exposure in return for security over the rest. You may read about creditors agreeing to redeem bonds at, say, 70p in the pound. That means that for every £1 invested, the creditor writes off 30p but the defaulter agrees to repay 70p.
■ Liquidity: Bond markets are many times bigger than equities, but ironically, the problem of illiquidity has plagued the UK private investor market for years. Wide spreads and patchy dealing have been common. One way around this, of course, is to hold bonds until redemption – thus sparing yourself dealing fees and some of the spread.
■ Call risk: some issues contain provisions allowing an issuer to redeem a bond at a fixed future price, usually in the context of a specific set of circumstances. This is often a feature of permanent interest-bearing shares and subordinated debt generally. Callable bonds also exhibit what is technically called 'negative convexity'; their prices are more sensitive to changes in interest rates than plain-vanilla issues.
