Bonds are an important asset class for helping many investors reach their goals. In particular, their reputation as a “safer” investment type often makes them attractive to those with a more “cautious” approach. For instance, people nearing or in retirement, who are likely to prioritise wealth preservation over wealth growth. However, UK bonds have had a tough time over the last 12 months due to political instability and both rising inflation and interest rates. In this article, our Teesside financial planners at Vesta Wealth explain how bonds can feature in a pension strategy and why 2023 could be a year of opportunities for some investors.
How bonds work
A bond is a type of “IOU” or “loan” where an investor lends money to a company or government on the promise of repayment (with interest). How often repayments are made vary depending on the bond – e.g. every business quarter or every 6 months – and the “coupon” refers to the fixed interest payment paid by the bond. The “price” is how much the bond would cost on the secondary market and the “yield” is used to measure the bond’s current income level relative to its price (e.g. by dividing the coupon by the current price).
Bonds have different maturity dates – i.e. lengths of time before the principal amount should be repaid to the investor by the borrower. These might be a year, 2 years, 10 years or much longer. Generally speaking, the shorter the maturity date the lower the yield you can expect (because a greater maturity date means more risk due to interest rate changes and the higher risk of not getting your money back).
Types of bonds
Stocks might vary in quality due to their underlying “fundamentals” (e.g. financial statements and balance sheets). Bonds, however, are rated by outside agencies like Moody’s, Standard & Poor’s, and Fitch, so investors know how likely they are to get their repayments. Bonds which are called “below investment grade” may present a higher yield, but also a higher risk of failure to deliver repayment. The better a borrower’s ratings, the lower the yield tends to be given the lower perceived level of risk. The UK government, for instance, issues bonds called “gilts” which are widely seen as very “safe” and so generally offer a low yield.
Bonds can also be offered by companies who ask investors to loan to them. These “corporate” bonds may be higher in risk than UK government bonds, since the company has a default risk. However, if this occurs, creditors usually get priority over equity holders (e.g. shareholders) – giving the former certain protections.
Note that bonds come with an inflation risk. If inflation rises during a bond’s lifetime, then the purchasing power of its future cashflows is eroded. However, whilst most bonds are fixed-rate investments, certain bonds are inflation-linked. This allows payments to rise with CPI inflation (Consumer Price Index) or another official measure. However, if prices fall, then the bond payments will do too.
Interest rates also impact bonds. In general, when inflation goes up, central banks (e.g. the Bank of England in the UK) tend to raise interest rates to counter rising prices. However, this puts downward pressure on the price of older bonds as the fixed interest rates they offer become less competitive compared to newly-issued bonds. Since the start of 2022, over £298bn has been wiped off the value of UK corporate bonds as the country grappled with repeated interest rate rises from the Bank of England.
How bonds can feature in a pension strategy
One useful aspect of bonds is that, as an asset class, over the long term they tend to have an inverse relationship with stocks. The value of the S&P 500 in the USA, for instance, has historically moved in the opposite direction to US Treasury bonds. Bonds, therefore, can be a useful diversification tool for an investor’s portfolio strategy. For instance, if an investor holds a 50:50 split in bonds to equities then, if the stock market crashes, this investor may see less short-term damage to her portfolio compared to someone holding 100% equities.
The proportion of bonds to other assets in your portfolio, however, depends on many factors for those in (or nearing) retirement. Your risk appetite is important. As a “safer” asset class, bonds may be appealing to those who are looking to minimise volatility in their portfolios. However, do note that bonds are not risk-free. In September 2022, for example, the UK bond market crashed temporarily after the government released its “Mini Budget”, sending investors into a panic over how tax cuts would be funded. The Bank of England needed to step in with promises of bond purchases to stabilise the market and prevent a full meltdown.
Your investor goals matter, too. Those looking to generate an income from their investments may find bonds an attractive investment due to the regular payments. Interest rates on bonds often tend to be higher than savings rates at banks, while also providing more predictable returns compared to stocks. For those looking to generate returns whilst protecting as much as possible against risk, bonds can be a valuable addition to an overall investment strategy.
Invitation
If you would like to discuss your financial plan and retirement strategy, then we would love to hear from you. Get in touch with your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.
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t: 01228 210 137
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This content is for information purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice regarding your affairs please consult your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.