Think carefully about swapping cash for bonds

They have not yet drawn on their individual savings accounts (Isa) and self-invested personal pension (Sipp) for regular income, or used any of their cash or NS&I Premium Bond savings. They want to use their savings and investments for income when Peter fully retires at 75, to fund care costs if necessary and leave a "useful sum" to each of their children as an inheritance. They own their own home, which is mortgage-free.

“I started seriously investing 25 years ago,” says Peter. “I have always spent time researching different investments, but now find this tiresome so want to let the managers of funds do the work. And most of the big losses we’ve incurred have come from direct shareholdings such as Royal Bank of Scotland (RBS), Tullow Oil (TLW) and Pennon (PNN).

“The Isas, which are our long-term investments, are almost fully invested. The Sipp has a high equity allocation alongside 13 per cent in cash. I’m conscious that this isn’t earning any interest, but I want to keep some dry powder for when the market turns. And I don't want the equity allocation to be much more than 60 per cent of the overall portfolio.

“I’m aware that the Sipp is efficient for inheritance tax (IHT) purposes, so when I fully retire at age 75 we will use what we hold outside the Isas and Sipp for income first. However, if we do that the allocation to equities will increase. So if we draw income from the Isas and Sipp we will not take more than the income generated via investing.

“I don't mind taking a relatively high-risk approach with the equity allocation as even if we lost 20 per cent of its value we would still have everything else to fall back on.

“I want to concentrate our portfolio in investment trusts I like such as Foreign and Colonial Investment Trust (FRCL), Witan Investment Trust (WTAN) and RIT Capital Partners (RCP), alongside some passive bond funds. I’ve also been thinking about whether I should invest in strategic bond funds, perhaps using the cash in the Sipp.

“I’ve recently sold J Sainsbury (SBRY), Vodafone (VOD), GlaxoSmithKline (GSK) and LF Woodford Income Focus Fund (GB00BD9X7109), and reinvested the proceeds in the investment trusts mentioned above.

“I have also thought about investing in the Vanguard Life Strategy funds, but I am concerned about their long-term performance. I hold Vanguard UK Inflation-Linked Gilt Index Fund (GB00B45Q9038), but this has underperformed my holdings in the Newton Index-Linked Gilt (GB00B01X0X00) and Schroder All Mature Index Linked Bond (GB0002634383) funds – although is cheaper.”

Peter and Madeleine’s portfolio

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS READER'S CIRCUMSTANCES.

THE BIG PICTURE

Chris Dillow, Investors Chronicle’s economist, says:

Compared with many investors you have quite a high cash weighting, but this is reasonable. The outlook for equities is lacklustre and risky, and as you may no longer be working in the near future it is a hedge against falling share prices. But some of this cash is in a Sipp, where it is likely to be earning especially poor returns. Ideally, your Sipp should be fully invested and your cash should be in accounts that pay higher rates of interest.

You are also letting the tax tail wag the investment dog. You might run down the capital held outside the Sipp and Isas first, even though doing this would increase your equity weighting. Doing this may be tax-efficient, but your equity allocation should be determined by the outlook for the market and your attitude to risk, rather than being an outcome of the sort of funds you hold. You should run down your wealth proportionately so that your asset allocation doesn’t change unless you want it to.

You must not let disappointment in poor returns drive you to take risks you would otherwise avoid. You’re thinking of shifting some of the cash in your Sipp into strategic bond funds. I’m not sure this is wise. There is a case for such funds. They protect us from some types of equity risk. If investors fear slower economic growth or become less keen to take risk they will shift from equities into bonds. So there’s a case for holding some bonds as insurance against some equity losses.

But this insurance comes at a price. It’s quite possible that bond funds will fall if US interest rates rise more than expected, or if low unemployment in the UK and US makes inflation rise – as economic theory says it should. In such a scenario cash would be more attractive than bonds. Just because cash offers poor returns today doesn't mean you should ditch it in favour of bonds.

Dan Dowding, relationship manager at Seven Investment Management, says:

It is good that you recognise the risk inherent in direct shareholdings, and your strategy of reducing exposure to these and using funds instead is good. You will benefit from a far better trade-off between risk and reward by investing in funds, which offer exposure to a very broad range of asset classes and markets.

You have sufficient capital to meet your needs, and with careful investment in a balanced portfolio of equity and non-equity investments you should be able to comfortably meet your income requirements targeting an annual return of 6 per cent. Your liquid assets – the cash, Premium Bonds, Sipp and Isa – will equate to over 65 years of income replacement once you stop working. Your illiquid asset – your home – also provides a good replacement.

The Sipp has a solid list of holdings and a back-test of its performance suggests that it has outperformed the FTSE All-Share index over one year with a return of 7.3 per cent against 6.4 per cent; over three years with 31 per cent against 30 per cent; and over five years with 63 per cent versus 44 per cent. This is assuming no changes have been made.

Your asset allocation suggests you are moderately adventurous, and although the high cash weighting has reduced the overall risk profile, it has been a drag on performance. You have about 40 per cent in UK equities, 9 per cent in Europe equities, 8.5 per cent in US equities, and 6.5 per cent in Asia and emerging markets equities.

Around 19 per cent is in direct shareholdings, primarily FTSE 100 high-yielders. I assume you selected these for their yields, but the direct equity exposure and concentration potential increases the overall risk of the portfolio. The overall historic yield seems to be around 3 per cent, which is reasonable but impacted by the high cash weighting.

The charges of the funds on the whole look reasonable, however the property funds’ ongoing charges range between 1.7 per cent and 2.2 per cent – which is quite high.

In the Isa, things are a little different. This has underperformed against the FTSE All-Share, with a return of 5.9 per cent against 6.4 per cent over one year. The asset allocation suggests it is adventurously positioned and, given the high exposure to direct shareholdings, it carries a higher degree of risk. The Isa is mainly invested in equities, with around 46 per cent in the UK, 15 per cent in the US and 12 per cent in Europe.

The historic yield of around 3.3 per cent is reasonable. However, Lloyds Banking Group (LLOY), Royal Bank of Scotland and Standard Life Aberdeen (SLA) have been poor mid- to long-term performers, and may have been a drag on returns, depending on when they were purchased.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You want to simplify your portfolio so you can spend less time managing it, which is sensible. Reinvesting direct shareholdings into investment trusts is a good idea as most of these are large defensive dividend payers, which you can retain exposure to via certain funds. Consider adding City of London Investment Trust (CTY) or Finsbury Growth & Income Trust (FGT).

Dan Dowding says:

The cash within the Sipp and Isa is a drag on performance, but lowers the overall risk profile. Cash is not zero risk and, if it is not generating a return at least in line with inflation, its spending power will be eroded over time.

It is hard to find good value in the fixed-income space at the moment because interest rates remain not far off all-time lows. Fixed-income bonds can be dangerous instruments in a rising interest rate environment, so take care when allocating to this asset class.

You are considering allocating some of the cash in your Sipp to strategic bond funds. These typically invest across the entire range of fixed income to offer diversification and allocate to the areas that offer the best returns for the risks they incur. This includes everything from gilts and company debt, to leveraged loans and convertibles, so has risk implications. 

Corporate bonds as an asset class look quite expensive – yields have risen, but spreads are still very low versus history. Emerging market debt looks attractive given that yields remain high and emerging market currencies are undervalued relative to history, but again there are risk implications. In view of all this, consider increasing your allocation to index-linked bond funds.

The Vanguard Life Strategy funds have low costs, but have a rigid asset allocation. A risk-managed portfolio, of which the asset allocation can be adjusted according to market cycles, will offer the potential for better performance.