The majority of investors are familiar with Gilts - bonds issued by the UK government to fund our ever-growing national debt. These bonds are issued with a range of maturities and are freely traded in the secondary market. Given the government-backed security of these bonds, the yields on offer will be comparatively low and reflect a risk-free return for the period. Studying how the yields vary over different maturities displays the gilt yield curve, a reflection of the market's expectation for future interest rates. At present, this yield curve is "positive" (see table below), meaning that longer-dated gilts yield more than shorter dated issues. This indicates that that the market expects interest rates to move higher in the future.
The gilt yield curve is an important concept for fixed-income investors, and is used as a benchmark for valuing corporate and other non-gilt bonds.
| Instrument | Term | Yield to maturity |
|---|---|---|
| Treasury 4.25% Dec 2011 | 2 years | 1.32% |
| Treasury 5% Sept 2014 | 5 years | 3.04% |
| Treasury 4.5% March 2019 | 10 years | 3.93% |
Moving on to the subject of corporate bonds, here the investors has a wide choice. Corporate and non-gilt bonds are issued by a variety of organizations, ranging from AAA-rated public-sector groups through to small and speculative companies. These bonds will offer an incremental yield or "margin" above that offered by gilts of a similar maturity, varying from just a few basis points for high-quality issues through to several percent for more speculative corporate debt.
There are hundreds of sterling bonds in issue, but sadly not all of these securities are liquid or even accessible by private investors. However, a selection of around 200 liquid corporate bonds can be found on the Investors Chronicle website (see www.investorschronicle.co.uk/bonds), these being the securities listed on the Bondscape system. This is the bond dealing platform used by the majority of stock brokers, and is a good place to start our selection process.
When selecting a bond for purchase, it is important to understand what you are buying. Price listings in newspapers and on websites typically look something like this:
Next Plc: 5.25% 30 Sep 2013 4 yrs 2 mths 99.1 5.42%
What does it all mean? The main components are as follows:
■ The issuer: This is the entity which is borrowing the money (in this case, retail group Next); determines the credit quality of the bond ( note credit ratings for bonds can be found on the websites of the two main agencies - Moody's and Standard & Poor's)
■ The coupon: The issuer commits to pay a rate of interest per year, in this cae 5.25 per cent. This coupon will generally be a fixed amount and is paid annually or semi-annually.
■ The maturity: A date is set for the repayment of the sum borrowed. This is known as the redemption date, in this case 30 Sep 2013. The bonds will be redeemed at "par" or 100p in the pound (with some rare exceptions). The '4 yrs 2 mths' is the time to go to redemption.
■ Price and yield: The indicated price (mid, in this case 99.1) of the security in the market and the corresponding yield to maturity (5.42 per cent).
■ Other features: Bonds can be issued with imbedded puts, calls and other potential pitfalls. The buyer should consider how these might affect the value. For instance, a bond with an issuer call option can be redeemed at par on the issuer's request - potentially limiting the holders upside in a bull market. Another important feature to be aware of is subordination - investors should ideally choose senior debt. Finally, consider the minimum dealing size. Most retail targeted bonds can be traded in increments of £1,000 - ideal for the private investor. However, the European Prospectus Directive has forced many more recent issues to have a minimum "piece" of £50,000, placing these instruments beyond the reach of many private investors.
So where to start? As with any investment, selecting bonds will depend on the investor's requirements - security of capital, income requirement, term of investment and many other variables.
With this in mind we have put together a list of tradable bonds, and considered how these might be utilized in two types of bond portfolios.
HOW TO DEAL
Having selected the bonds you wish to purchase, check the price with your stockbroker. You will probably have to do this by telephone - very few bonds can be dealt online at present.
Liquidity and bid-offer spreads are variable and dealing can be difficult. High quality bonds such as Gilts and EIB issues generally trade on tight bid-offer spreads, but these can be wider in higher yielding and more speculative debt. The situation is currently acerbated by strong retail demand from the start of the year and a shortage of retail-targeted new issues.
Dealing effectively is important - you are buying these instruments for yield, not for fun. Do not be afraid to haggle on the price, or leave an order with your broker to work. Finally, keep an eye on new issues in the press (such as the Capital Markets section of the FT). New issues are often well-priced and good value with tight bid-offer spreads.
BUILDING A PORTFOLIO
Bonds should be held as part of a portfolio -not as a few scattered holdings. Professional fund managers typically use the "ladder" structure where holdings are ranged across different maturities. This allows a steady stream of redemptions to keep the cash flow coming back in to the portfolio.
For investors looking to put together a low-risk portfolio, from high-quality holdings, the degree of diversification can be fairly low. For instance, a sample portfolio might look as follows:
| Bond | Maturity | Price | Yield |
|---|---|---|---|
| Gilt 5% March 2012 | Three years | 106.86 | 2.28% |
| EIB 4.375 Jul 2015 | Six years | 103.83 | 3.6% |
| EIB 4.125% Dec 2017 | Eight years | 99.63 | 4.1 % |
However, more adventurous corporate bond portfolios will need a higher level of diversification - probably at least ten holdings. This will ensure that one bad position will not wipe out the portfolio. The ladder structure should be adhered to, but in addition to this concept investors should ensure that their portfolio ranges across different sectors with holding from different industry groups such as banks, retailers, utilities etc.
WHAT ABOUT TAX?
The first piece of good news is that profits on bonds are generally considered to be free of capital gains tax. However, the majority of the return from a bond portfolio will be achieved from the income received from coupon payments. Whilst these coupon payments are paid gross, they are certainly subject to income tax.
Luckily, Isas and Sipps offer two easy methods to achieve shelter from income tax - allowing the power of compound interest to roll up over the years.
To qualify for an Isa, a bond must have a maturity of five years or more (including any holder put options). All income and capital gains achieved within an Isa are free from tax.
The situation for Sipps is even easier. Bonds of any maturity can be held within a Sipp. These can be used as a high-yielding substitute for the cash component of the portfolio, as a diversification from equity or as an income generator during the latter years of the scheme.
In theory, bond purchases are free from stamp duty, and this will be the case within normal market settlement where the bonds are delivered into a Euroclear account. However, many private client stockbrokers use a delivery mechanism known as Crest Depository Instruments (CDIs). Due to a quirk of HMRC's system of classification, these are attracting Stamp Duty Reserve tax on purchases (0.5%).
GOLDEN RULES:
■ Avoid always buying the cheapest, highest yielding bond on the list; you will end up with a portfolio of junk!
■ Try to spread purchases across both a range of sectors and a range of credit qualities and select bonds that pay coupons across the calendar.
■ When possible, to buy bonds at prices below par in order to preserve capital. However, good bargains can often be found in bonds trading above 100.
