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How to choose a bond fund By Rob Griffin
The simplest definition of a bond is an I-O-U. By buying a bond, you are effectively lending money to the issuer in exchange for a fixed rate of interest over a pre-determined period, as well as your original investment returned Government bonds The safest type of bonds are those issued by governments - particularly ones issued in stable countries like the UK and US. However, reliability is a double-edged sword. The risk to your capital is very low, but the flip side is they offer a lower rate of return than riskier products. In the UK, bonds issued by government are known as 'gilts' - the name is a shortened version of gilt-edged securities (certificates used to be gilt-edged) - and can be freely traded on the stockmarket. The gilt market is broadly split into two distinct areas: conventional gilts and index-liked gilts. With conventional gilts, government agrees to pay the holder a fixed cash payment (a 'coupon') every six months until the maturity date, at which point the initial sum invested (the 'principal') is returned. Gilts are denoted by a combination of the coupon rate and maturity date, such as 4% Treasury Gilt 2016, and there are always plenty of gilts in the market at any one time. In most cases, the Treasury issues gilts with maturity dates that are five, 10 or 30 years into the future. These products are different to index-linked gilts, where both the coupon and the principal are adjusted in line with the UK Retail Prices Index (RPI). This means that both will take into account inflation since the gilt was first issued. The method used to calculate the cashflows on these gilts will vary according to the date on which they were issued. Corporate bonds Alternatively, you can invest your money by lending it to companies. This is riskier than gilts, because there's no guarantee that your investment will be repaid in full - the company may go bust or be unable to meet its interest payments. Specialist credit agencies, such as Standard & Poor's, apply a rating based on their assessment of a firm's ability to repay the sum borrowed. The most trusted will be given a triple-A (AAA) ranking, then it goes down on a sliding scale through AA, A and BBB. Anything rated BBB or above will be classed as investment grade; anything below is known as high yield or 'junk bonds'. Both the amount of risk you are taking and the level of your potential return will increase as you move down the ratings scale. Each bond will have a nominal value - usually £100. This is the price that will be paid to holders when it reaches the end of its life. Although life spans will vary, they are generally less than 10 years. Bond trading As they are traded on the stockmarket, the price paid for a bond can vary. For example, if it was offering a return of 6% and interest rates were well below that level, it would be attractive to potential investors and the market price could increase by, say, 10% to £110. However, if interest rates were on the up, then the fixed rate wouldn't look so appealing and the price could fall to under £100. No one who buys a bond at the nominal price will be affected by fluctuations in price as they will receive the nominal price back at maturity. Obviously, those who paid less than the nominal value will make a capital gain on maturity, but anyone who paid more will be staring at a loss. Price and income The yield is the amount of income you receive from bonds. The fixed interest being paid on a bond is expressed as a percentage of its face value. If the market price changes, however, this interest rate still applies to the original face value. So, as the price of a bond moves, so the yield percentage changes. For example, a bond with a nominal (face) value of £100 earning 8% interest will yield £8 every year. By multiplying this £8 by 100 and dividing it by the market price (which, if you paid the nominal price, is £100), you will get a yield percentage of 8%. However, do the same calculation with a bond that has a face value of £100 - but which was bought for £120 - and you will get a yield percentage of 6.66%. Another way of assessing the attractiveness of a particular bond is to look at the gross redemption yield, which is a percentage figure that takes into account the price paid for the bond, the rate of interest paid and any capital gain/loss that you are liable to make if you hold it until maturity. Of course, this only applies to individual bonds and not bond funds, such as unit trusts, investment trusts or open-ended investment companies, as these invest in a range of corporate bonds and gilts. Factors that can influence the price include the belief of market analysts that a particular company isn't doing well, merger and acquisition activity, rising interest rates and inflation. According to Chris Bowie, the head of credit at Resolution Asset Management: "Inflation is the ultimate no-no because it destroys your future returns. What you're buying with bonds is a fixed amount of income every year. If you get a lot of inflation before that bond matures then those income payments and the principal you get back at the end will be worth a lot less." So what's the ideal backdrop for bonds? "What makes us the most money also causes the most economic hardship for the rest of the population and that's why we're seen as doom-mongers," says one bond fund specialist. "The biggest kick for bonds would be a recession that led to the threat of deflation." Why hold bonds? So what role can bonds play in your portfolio? According to Darius McDermott, managing director of Chelsea Financial Services, the principle reasons for holding bonds are to reduce the overall risk of a portfolio and to produce a decent level of income. Someone who ties up all their money in equities could end up losing a huge amount if the market suddenly falls. That's why the percentage of their portfolio that's held in bonds should increase the closer they get to retirement. "When you've got 30 years of work left you can afford to have, say, 85% in equities and 15% in bonds," McDermott says. "But, if you've built up a pension pot of half a million pounds and there's only three years until you retire, you don't want to take the risk of the equity market crashing." It is possible to buy bonds direct. Gilts can be bought through a government department called the UK Debt Management Office (DMO) or 'second-hand' through a stockbroker. Corporate bonds can also be purchased through a stockbroker. However, in most cases, the simplest of getting exposure to the asset class is by investing in a gilt or corporate bond fund whose manager will select the best bonds to invest in. McDermott advises people to stick to household-name funds and managers, with good track records, such as Aegon, Invesco Perpetual and Old Mutual. With gilt funds, the benefits of tapping into the skills of a professional manager has to be weighed against the charges and the risk of a capital loss, as you can't hold a particular gilt until its redemption date. But if you're happier with a gilt fund manager, then it might be worth looking at something like the Newton International Bond fund, which can give you the prospect of making improved returns as it invests in both the UK and overseas governments.
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