Investors can help reduce risk in their portfolios by diversifying into bonds, which are also known as ‘fixed income’. These debt instruments have, historically, tended to be less volatile than equities, so they can be a stabilising influence in portfolios. Bonds can seem confusing, but as one of the main asset classes it can benefit investors to understand their characteristics and the investment role that they can play.
What is a bond?
A bond traded on financial markets is effectively an IOU (‘I Owe You’) issued by a government body or a company in return for your investment.
The government body or company promises to make an interest payment known as the coupon to the holder of the bond, usually annually or semi-annually. Normally, an amount called the principal, also known as face or par value, will be given to whoever holds the bond when it ‘matures’ after a pre-set term, such as five, 10 or even 30 years. Sometimes, however, bonds are ‘perpetual’ and never mature. In this case investors will receive payments in perpetuity – theoretically forever – but the principal is never redeemed.
Types of bonds
The bonds traded on financial markets are either issued by state bodies, such as central and local governments, or companies. For example, bonds issued by the US or UK governments are called treasuries and gilts respectively. Companies issue ‘corporate bonds’.
Beyond these two basic types, bonds can come in many shapes and sizes. They can vary according to their terms to maturity, the interest rates and currencies they pay, who the issuers are and their creditworthiness, where they are issued and the purposes for which the proceeds of bonds are used.
What are bond ratings?
The chances that bondholders will receive interest payments and the return of the principal at maturity depends on the financial reliability of a bond’s issuer. A financially-strong multinational firm, for example, would pay a lower rate of interest on its bonds than a small, less established company. This is because it is a lower-risk investment, in theory at least.
Investors can get a good indication of this reliability from the credit ratings given to companies and governments by rating agencies such as Standard & Poor’s, Moody’s and Fitch. Each agency has its own set of ratings, but examples include AAA (for the most reliable issuers), and Aaa, BBB or D (for higher-risk issuers).
The low-risk bonds, usually BBB-rated and higher, are known as investment grade and lower-rated bonds are known as high-yield, or junk bonds because of the greater likelihood of the issuers defaulting on the debt.
These ratings are publicly available and are widely used by industry professionals and investors.
What are bond yields?
The bond yield is the measure of return on a bond. It can take several forms, but ‘yield to maturity’ (YTM) is the most common measure. This is the return on a bond if it is held to maturity and all the coupons are reinvested at the YTM rate. Other measures include the current yield, which is the annual coupon divided by the bond’s current price; and the nominal yield, which is the annual coupon divided by divided by the face, or par, value of the bond.
Are bonds a good investment?
Bonds hold several attractions for investors. The first is that they can add stability to a portfolio. This is because of the relative certainty of the income streams they provide. ‘Hard currency’ bonds issued by advanced countries such as the US, for example, are normally seen as the safest bonds of all because of the relative security of the income. Companies must also prioritise paying their bond holders their dues before giving their shareholders any dividends.
Bonds offer a vast range of investment options. The bond market is much larger than that of equities and governments and companies issue bonds all around the world. This choice enhances the potential for investors to counter risks through effective diversification of their portfolio.
Recent years have also seen strong growth in the market for bonds that enable investors to integrate Environmental, Social and Governance (ESG) factors into their investments. These bonds raise finance for ESG-related purposes, such as clean energy projects and social housing.
Are there any risks with investing in bonds?
As much as bond prices tend to be more stable than equities, they still rise or fall depending on what the market thinks about the creditworthiness of issuers, and the actual and expected inflation and interest rates.
There is an inverted relationship between interest rates and bond prices. If the interest rate on a bond rises, then its market price will fall to reflect the fact that a higher interest rate is being paid, and vice versa. This will be influenced by conditions in the wider economy. If, for example, a central bank raises the base rate then interest rates in the domestic financial system will rise, too. This will pressure the prices of existing bonds to fall to reflect the higher interest rates more widely available, while new bonds will likely have to offer higher interest rates, too. The aggressive rate hiking by central banks to combat inflation in 2022, for example, was particularly damaging for bond prices.
Bonds are also vulnerable to inflation. Coupons are usually for a fixed nominal amount so their real value will be eroded over time by inflation. Inflation expectations are priced into bonds but if prices rise more strongly than expected at any stage then bond prices will fall to reflect the fact that the real value of their income streams will reduce. Some bonds do pay coupons that rise in line with inflation, however. These are sometimes described as ‘index linked.’
Finally, the coupons that governments or companies pay on their bonds are directly linked to their creditworthiness, or their ability to pay. If the government or company issuing the bond gets into financial trouble, they could default on payments. In this case, the bondholder will get back less money than they expected, or possibly nothing at all.
Liontrust bond funds
Liontrust bond funds are available via both the Global Fixed Income (GFI) and the Sustainable Investment (SI) teams.
The GFI team’s investment process aims to identify opportunities overlooked by other investors in the market by having a thorough understanding of the economic environment and conducting in-depth analysis of individual stocks. The team applies analysis based on fundamentals, valuations and technical factors to individual stocks and the wider economy. Funds offered by the GFI team include:
Liontrust Strategic Bond Fund – Invests in a range of government bonds and other credit securities globally. For more information, see here.
GF Absolute Return Bond Fund– Invests in corporate and government bonds worldwide, including developed and emerging markets, to generate a positive absolute return over a rolling 12-month period by aiming to minimise volatility and reduce the possibility of a significant negative return. For more information, see here.
GF High Yield Bond Fund– Invests at least 50% of its assets in bonds globally that are classified as below investment grade but offering higher rates of interest. The Fund may also invest in government and investment grade corporate bonds. For more information, see here.
Bond funds managed by the Liontrust Sustainable Future (SF) investment team include:
SF Corporate Bond Fund – Invests at least 80% of its assets in investment grade corporate bonds that are denominated in, or hedged back to, sterling. For more information, see here.
SF Monthly Income Bond Fund– Invests at least 80% of its assets in investment grade corporate bonds denominated in sterling or hedged back into sterling to reduce currency risk. For more information, see here.
GF SF European Corporate Bond Fund – Invests predominantly in euro-denominated investment grade corporate bonds or non-euro denominated corporate bonds hedged back into euros to maximise income and capital growth returns. For more information, see here.
KEY RISKS
Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested.
The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.
DISCLAIMER
This is a marketing communication. Before making an investment, you should read the relevant Prospectus and the Key Investor Information Document (KIID), which provide full product details including investment charges and risks. These documents can be obtained, free of charge, from www.liontrust.co.uk or direct from Liontrust. Always research your own investments. If you are not a professional investor please consult a regulated financial adviser regarding the suitability of such an investment for you and your personal circumstances.
This should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy. The investment being promoted is for units in a fund, not directly in the underlying assets. It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, forwarded, reproduced, divulged or otherwise distributed in any form whether by way of fax, email, oral or otherwise, in whole or in part without the express and prior written consent of Liontrust.
