Understanding the basics of bond investing
Whether you’re new to investing or looking to diversify your portfolio, understanding bonds...
Last week we looked at how to start a portfolio, and I mentioned finding a balance with your investment choices. So this week, to help you along in your research, I wanted to take a look at what exactly you can invest in: delving deeper into the six general investment ‘assets classes’ we so often discuss on FundCalibre, as well as the level of risk associated with each.
‘Personal finance is about 80% behaviour and only about 20% head knowledge.’
– Dave Ramsey, personal finance author and radio host
The first ‘asset class’ we come across in our lives is cash. For most people, cash is held in a bank account and earns a rate of interest which is paid to us by the bank. The problem with holding all your money in cash is that interest rates can be poor and, when you take inflation into account, your money could be losing value over the long-term.
Think about it this way: if your account is paying you 1% each year, but the cost of living is rising by 1.5%, that money you are saving will be able to buy you less and less as time goes by.
That’s not to say you shouldn’t have any money in cash – you should. That emergency fund we’ve talked about before, for example. But, over the long-term, investing your money in one of the other asset classes could provide a better return.
When we talk about equities we are talking about owning some of the shares of a company. When you own shares, you can vote on how the company is run. When a company makes a profit it has a choice as to what it does with that profit. It can reinvest in the business or it can pay some of the money back to its shareholders in the form of a dividend.
Individual equities are relatively volatile in the short-term because the share prices move frequently. If you own shares in BP for example, they could go up in value in at 9am and then fall in value just a few minutes later. So rather than rely on the fortunes of one company, some investors prefer to hold shares of a number of companies through an equity fund.
Funds can also pay a dividend. This happens when the companies in which a fund invests pay dividends, and the fund passes on these payments to its investors. A dividend-paying equity fund was the first example I gave last week and I balanced it with a bond fund for the reasons below.
Bonds, or fixed-interest funds, come in a variety of shapes and sizes from government to high yield, strategic and more, but what are they and why was a bond fund a good match for an equity fund in my previous article?
A bond is a loan. Only instead of you borrowing money from a bank, a government or a company is borrowing money from you. By buying that bond you are agreeing to loan them the money in return for a fixed interest payment over a certain amount of time. But not all bonds are created equal and, while most are deemed less risky than stocks, they still carry the risk that the government or company will default on the loan.
High yield bonds, for example, can be issued by either governments or companies and are deemed higher risk. To compensate for this higher risk, the yield (or income paid) on theses bonds tends to be higher.
Last week I looked at a corporate bond which invests in investment grade bonds – meaning they’re deemed to be from a better quality company and less risky compared with a high yield bond. This offset any potential risk I felt I had by investing in an emerging markets equity fund.
Absolute return funds aim to deliver positive returns in all market conditions (although this isn’t guaranteed), with low volatility. This sector is very varied and while some funds will invest in just equities, others will invest anywhere and in a variety of assets, so if you are considering investing in an absolute return fund, make sure to look at the funds individually.
Property doesn’t have to mean buying a house. Of course, owning your own house or being a landlord can also generate income in the form of rent or capital appreciation. But investors can also get exposure to the real estate market through either physical property funds or a property shares fund.
Physical property funds invest in residential or commercial property, like student accommodation or buy-to-let, shopping centres, sports complexes, office blocks, ship yards and more. They invest in the physical properties themselves, meaning they own the buildings.
Conversely, you can have funds that own shares in companies related to property. This might include real estate investment trusts or property-related businesses like hotel groups or self-storage companies.
If all that choice is too much for you, and you are not sure how you would balance your own portfolio, you could opt for a multi-asset fund. As the name implies, this type of fund invests in more than one asset class – often all of those I have mentioned and more besides. The fund manager then alters the amount invested in each asset class depending on the prevailing market conditions.