Advice on switching equity portfolio to bonds

PAUL MACDONALD'S SHARE PORTFOLIO

FUNDS HELD ACROSS SIPPS, ISAS AND TAXABLE FUND PORTFOLIO

Baillie Gifford Global Discovery (ISIN: GB0006059116)

Fidelity Global Property (ISIN: GB00B1BXCS68)

Fidelity South East Asia (ISIN: GB0003879185)

Henderson European Selected Opportunities (ISIN:GB0032437948)

Invesco Perpetual Money (ISIN: GB0033029413)

JPMorgan Natural Resources (ISIN: GB0031835118)

M&G Strategic Corporate Bond (ISIN: GB0033828137)

Neptune Russia and Greater Russia (ISIN: GB00B04H0T52)

Newton Asian Income (ISIN: GB00B0MY6Z69)

BONDS HELD IN ISAS

Intermediate Capital Group 7%

Provident Financial 7%

Chris Dillow, the Investors Chronicle's economist says:

This portfolio raises the question facing thousands of us approaching retirement: how to convert our volatile equity holdings into a stable bond-like income stream when we retire.

If you look only at economic forecasts, there's no problem. Over the next few years, some kind of global economic growth should raise both share prices and bond yields. In four years' time, then, you should have an even bigger equity and fund pot, with which to buy safe bonds that yield more than they do now. Easy.

However, we must never base investment decisions solely on central scenarios. We must also consider risks. We can, roughly, quantify this. Let's assume your equities and equity funds have an average annual real return of 5 per cent, with standard deviation of 18 per cent; this is a little lower than the market's long-term volatility, reflecting your big holdings of relatively defensive stocks. It then follows that there's a greater than one-in-four chance of your equities losing money over the next four years, and an almost one-in-five chance of a loss of 10 per cent or worse.

(These numbers aren't meant to be exact; there's no point chasing a spurious precision. They are meant to be a roughly reasonable picture of likely risks).

What's more, many of the circumstances in which shares fall would be those in which bond yields fall further; this would be the case if the world economy falls back into recession. In this case, we face the double problem of having less wealth, and facing low income from the bonds we can buy with that wealth.

The obvious protection against this risk is to hold more bonds now. Doing so does more than merely help protect you against many sources of equity risk - such as increases in risk aversion or fears about economic growth that lead to higher bond prices. It also provides a direct hedge against falls in future bond yields and hence in our retirement income - because such falls raise the value of our bond holdings.

There are, of course, reasons not to do this. Bond prices are now very high, reflecting the fact that so many want to buy protection against falls in share prices. And if the central economic forecast comes right, we will lose money on those bond holdings as prices fall and yields rise.

There's no way around this trade-off. How you solve it depends ultimately on your personal preferences. To clarify the question, your current wealth would give you a nominal income in perpetuity of just over £90,000 - more, of course, if you self-annuitise, but less (initially) if you want to protect it against inflation. Is this enough to finance your future lifestyle? (Be honest here: don't think: "we can cut back later" because if you don't fancy cutting spending now, you won't fancy doing so in future.)

There are, roughly, three possibilities here:

■ This income is just at the level you need. If so, then falling share prices will jeopardise your future lifestyle. Why take a risk to generate income you don't need?

■ This is below the level you need. If so, you might need to take on equity risk to get your income up; such risk, remember, will probably pay off.

■ It is well above the level you need, such that you can afford to take the risk of a lower income, perhaps in exchange for being able to (ultimately) leave a big bequest.

The answer here is a personal one. My point is merely that you should keep your eye on the target - which is how much income you'll need in four years' time.

Ben Yearsley, head of investment research at Charles Stanley Direct, says:

It looks as though you want to take income from the Isa and investments, and possibly do income drawdown from your Sipps. However, you will still both be in your 60s when you do this and potentially have another 25 years or more to live, so being in fixed income with no possibility of any growth in that income for that long isn't the best idea. You should consider an element of equity income in your long-term planning to give some capital growth, a reasonable starting yield and the possibility of rising income.

You have a long list of shares, which is fine as long as you monitor them closely. BHP Billiton and Shell offer well-covered dividends from dollar denominated commodities, providing good protection against the twin threats of UK inflation and sterling depreciation. Moreover, neither has shared in the general equity rally so far this year, which provides comfort that a downward correction is not around the corner. In both cases, the market has worries about the return on future capital expenditure, but both companies have got the message and will be careful about how they invest money.

Another good holding is First Group, a bruised and battered stock but for which the bad news is probably in the price so a good contrarian play. Just don't rely on the dividend: the yield is 11.45 per cent which shows that the market expects a cut, while a rights issue is not out of the question.

Not so good are the holdings in AstraZeneca and Tesco. AstraZeneca is not really doing anything for the portfolio that GlaxoSmithKline doesn't, and the stock has enjoyed a marked bounce since relatively new chief executive officer Pascal Soriot set out his plans last month. He now has to deliver, which will take a long time. You could look at Shire (SHP) as a possible alternative, which doesn't offer much in the way of income but does have good growth prospects.

Tesco has had a strong run on hopes that the US arm is going to be closed, so it could be a case of buy the rumour and sell the fact. A possible alternative is Sainsbury (SBRY), a much steadier ship of late and unscathed by horsemeat scandal, or Morrison (MRW) which has lagged behind in getting into the growth areas of online and convenience stores, but is now moving to make up for lost time.

None of the funds are an outright sell, but I am not sure if they fit your long-term strategy. You say you are medium to high risk, although your portfolio looks more high than medium-to-high risk. Fidelity South East Asia, JPM Natural Resources and Neptune Russia are all high-risk funds as they could fall or rise 20 per cent or more in a very short space of time. It doesn't seem right having a high-risk strategy for the next four years then switching to bonds. To start balancing the portfolio you should start adding some equity income funds that give capital and income growth prospects.

You say that your wife has £169,000 cash available to invest in her Sipp. I would look at putting all of this into equity income funds, dripping in over the next six to nine months. A few to consider include River & Mercantile UK Equity Income (GB00B3KQG330), JO Hambro UK Equity Income (GB00B03KR617) and Invesco Perpetual UK Strategic Income (GB00B1W7J535). I would also look to add in some global flavour with funds such as the Aberdeen World Growth & Income (GB00B3N9CY25) and First State Global Listed Infrastructure (GB00B24HJR07).

You should also add some more bond funds as you sell out of the higher-risk holdings either now or over the next couple of years, ensuring they have a mix of investment-grade, high-yield and strategic bonds. Jupiter Strategic Bond Fund (GB00B2RBBC80), (an IC tip), is a good option, although with strategic bond funds the income paid can fluctuate quite a bit as the portfolio moves around.

Ultimately I would be looking for a portfolio of between 15 and 20 funds with a mix of equity income, predominately from the UK, and bond funds. This doesn't have to happen overnight as you say you are happy with the higher-risk approach for the time being, although I think the portfolio is too high risk if you only want another few years of growth.

I also don't see the point of holding money funds if you have substantial cash reserves elsewhere.