Can bond promise continue into 2023?
This article first appeared on professionalparaplanner.co.uk on 14th December 2022 For the past few...
I can think of a whole list of things that are boring and mundane… but that are also good for us. Whether it’s paying the bills, eating leftovers, or compiling spreadsheets, these things all have value, but while we’re doing them, they just seem dull and tedious – a bit like fixed interest investments!
After three years working in the world of investments, I am still baffled by bond markets. Yes, it’s debt, but there’s so much more to it than that and jargon is everywhere. They say the best way to handle boring tasks is to either make them interesting or to make them an unconscious habit. Making bonds interesting seems like the harder of the two…
“He who is quick to borrow, is slow to pay.” — German proverb
In an effort to understand fixed interest a little more, I’ve organised a comprehensive reference guide. But first, what is a fixed interest investment?
Fixed interest is another word for bond and simply put, a bond is a loan. By buying that bond you are agreeing to loan either a government or company the money in return for a fixed interest payment over a certain amount of time.
As anyone who has searched for a loan will know, there is more involved than just your credit score and the amount borrowed. Whether you choose to pay it back over 2 years or 6 years will also make an impact on your approval. The same goes for bonds. The two main features of a bond are the maturity date and the credit quality.
If the issuer of the bond has a poor credit rating it means the risk of default is higher – they may not pay the loan back. These bonds will therefore pay a higher interest rate or yield to compensate you for taking that risk. Bonds with a longer maturity date usually have a higher interest rate too because you’re exposed to not only default risk but also other factors like inflation for a longer period.
Bonds are given a rating, or a grade, to indicate the level of credit quality and they’re awarded by bond-rating agencies, not the issuer. These ratings use a letter system which ranges from AAA (the best) to C (the worst). To simplify the jargon, we typically refer to investment grade or high yield bonds.
Investment grade means the bonds are considered higher quality and less risky companies by credit rating agencies. On a factsheet this would generally mean any bond rated AAA to BBB. High yield refers to those bonds rated BB or below, with the risk increasing as you move down the scale. You will typically see yields increase as the ratings decreases to account for higher level of risk.
|Bond Rating||Grade||Risk Level|
|AAA||Investment Grade||Lowest risk|
|AA||Investment Grade||Low risk|
|A||Investment Grade||Low risk|
|BBB||Investment Grade||Medium risk|
|BB/B||High Yield||High risk|
|CCC/CC/C||High Yield||Highest risk|
Bonds are also “rerated” – usually on a quarterly basis. This can give us what we call fallen angels or rising stars. Fallen angels are bonds that were once investment grade but have been downgraded to high yield. Rising stars are the opposite – the rating has been increased with the company’s improving credit quality. However, this doesn’t mean the bond has become investment grade, it can refer to a B bond rerated to BB as well.
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. Bonds will typically fall into two categories: corporate or government bond.
Corporate bonds, as the name suggests, are issued by companies. They’re then generally divided into two sub-categories: investment grade and high yield. For example, the M&G Corporate Bond fund currently has almost 79%* in investment grade corporate bonds, just under 19%* of which are rated AAA – or the highest quality bond.
Government bonds explicitly invest in bonds issued by governments. You may hear them referred to as ‘sovereign debt’, ‘Gilts’ (UK) or ‘US Treasuries’. Since these loans are backed by governments, those in developed markets are considered less risky while those in emerging markets carry a higher risk.
FundCalibre doesn’t currently rate any explicit government bond funds, but many funds invest in them as well as corporate bonds. For example, Allianz Strategic Bond has over 90%* in government bonds with 50% rated AAA. In comparison, the M&G Emerging Markets Bond has 69%* in government bonds, but the majority of credit is in the B – BBB range, meaning it’s slightly riskier, but should offer a higher yield.
Strategic bond funds are the most flexible type of bond fund. They can invest in any type of bond – government, investment grade, high yield and emerging market, as well as other fixed interest investments. TwentyFour Dynamic Bond is one such fund. It invests around the globe and currently has nearly 25% in banks and 14% in government bonds*. The Baillie Gifford Strategic Bond has more familiar names with Netflix, National Grid and Virgin Media all in its top ten*.
High yield bonds, as the name suggests, offer a higher yield but that’s because the risk with these bonds is higher. They can be issued by either companies with low credit ratings or emerging market governments. Man GLG High Yield Opportunities is a global high yield bond fund with the majority of the portfolio in B rated bonds. It offers a yield of 5.66%*. Baillie Gifford High Yield Bond is another option in this category. It invests predominantly in the UK, US and Europe, with just under 57%** in BB rated assets and current yield of 4.20%*.
Fixed interest is complex. The above guide explains the typical ways that investors access the bond market, but there are many special types of bonds available. For example, zero-coupon bonds or convertible bonds. A convertible bond gives the bondholder the right to exchange their bond for shares of the issuing company, if certain targets are reached. The SVS Church House Tenax Absolute Return Strategies fund currently has 7.5%** invested in these types of bonds.
Learn more about the structure of company debt in the video below which covers senior secured debt through to stocks in a company.
*Source: fund factsheet, 31 May 2021
**Source: FE fundinfo, credit weightings as at 30 June 2021