‘How to Invest’ is a series of articles guiding readers through the basics of investing in different assets. See also: The risks of leaving money on deposit, how to invest in shares and how to invest in a fund
Earlier this year, the Financial Times wrote that the “appetite for bonds in an uncertain world is back in a big way”.
Bonds traditionally have been seen as a way of reducing the level of risk in an investment portfolio. That is why, for instance, the Pensions Authority pressed sponsors of defined benefit or final salary pension schemes to cover their liabilities with bonds rather than shares. The returns might not be as spectacular but they are seen as more stable, especially where the issuing authority is a country.
But how best to invest? How much it will cost and what are the risks?
This week, in our series on how to invest, we take a look at everything to do with bonds.
Why invest in bonds?
Put simply, when you buy a bond from an issuer – which could be a government or company – it’s like you are giving them a loan, usually for a fixed period of time and at an agreed rate of interest. This interest is known as a coupon and is paid at regular intervals. But your return is also determined by the performance of your capital – the bond itself – if you sell your investment before maturity.
Bond prices move inversely to interest rates. That means that as interest rates rise, the rate on offer on a bond looks less attractive and the price declines. When interest rates fall, bond yields look more favourable and bond prices rise.
This complexity is the “biggest hurdle” for many investors, says Elizabeth Geoghegan, head of fixed income strategy at Goodbody.
“Equities are a lot more straightforward as they just have one variable, the price,” says Geoghegan, “but bonds have two factors to consider – the interest rate – is it going up or going down? – and then the price as well”.
But the beauty of bonds, she adds, is their certainty: when you buy a bond, you have a promised yield, that if you hold to maturity, will be locked in – at least if the issuer does not default.
Colm McDonagh, chief executive of Insight Investment Management, characterises investing in bonds as a contractual investment, and likens it to the reverse of people getting mortgages – now you’re the lender, not the borrower.
When it comes to the reason to consider bonds in an investment portfolio, the first role of bonds is diversification, says Geoghegan.
Typically, bonds might have accounted for about 40 per cent of a portfolio, offering a non-correlated asset to equities, meaning that traditionally they have not risen or fallen in tandem with shares. This “worked very well”, says McDonagh. However, he adds, “there is now a good question as to if that’s the right allocation going forward”.
This is because the correlation changed around 2022, as bonds came under pressure at a time of rising interest rates. A recent report from the IMF found that equities and bonds are increasingly moving in tandem. That being so, future investment strategy might be less about allocating to bonds, and more about how you allocate within the asset class, says Geoghegan.
The upside, however, is the income that bonds can now generate.
“Before 2022, interest rates were negative: today bonds offer really healthy positive yields,” says Geoghegan. “The big benefit in that change is you have very healthy interest income that you didn’t have before”.
Irish 10-year bonds – ie bonds that are issued purely for a 10-year period – are currently yielding about 3.24 per cent a year, for example, while German Bunds are less than 3 per cent.
“The big advantage of bonds, and what makes looking at bonds so [much] more exciting today than 2022 is that power of compounding interest,” says Geoghegan, adding this can be enhanced “by going into corporate bonds that have that additional yield”.
Your total return from a bond comes in two forms; your coupon, and whatever capital gain is made on the price.
If you buy a bond below par, for example – which means it’s trading at a discount, typically because the price has fallen due to a rise in interest rates – you could get a decent capital return on the bond as you will receive the full value at maturity.
And, meantime, you are also getting your coupon every year.
How to invest?
As with equities, you have a number of choices when it comes to investing in bonds.
First of all, you can buy an individual bond, such as Irish Government bonds, US treasuries or emerging market sovereign bonds. When such bonds are first issued, the market is typically limited to institutional investors, so when you see the National Treasury Management Agency (NTMA) – which manages Ireland’s national debt and issues bonds on behalf of the State – issue a bond, you won’t be buying it on the date it issues. A secondary market means you can subsequently invest through a broker.
Corporate bonds are another option. Here, rather than lending to a country, you are buying debt in a company such as Ryanair, or Apple. These can offer a greater return than government bonds because the State is considered a safer pair of hands when it stands over its bonds as against an individual company doing so.
“Corporates should always trade at slightly higher yields than a government,” says McDonagh.
Geoghegan notes, however, there can be restrictions on retail investors investing directly in corporate bonds, so the typical route for a private investor is through a fund or an ETF.
Bond funds, which allow you to invest in a variety of bonds from different issuers in different jurisdictions, can be a way of potentially chasing a higher yield while mitigating risk.
“There is a massive universe out there,” says McDonagh, adding that funds are “typically less risky as you have diversification”.
Unlike equity investment, where cheap passive index funds are the first port of call for many, passive bond funds tend to be less popular. Typically, investors in bonds tend to prefer an active option.
There are several reasons for this. First, new bonds are issued all the time. Buying an index-tracking fund only replicates the bonds in issue at that time, not others that become available over the life of your investment.
Second, bond markets are seen as offering active investment managers more scope for profiting from things such as pricing disparity.
With an active fund, you’ll have a team of credit analysts making the decision on the fund on your behalf.
“There is a lot of desire for active managers to make that decision around the quality of the contract, and which regions you want to invest in,” says McDonagh.
You can put your money into a bond fund in a variety of ways:
– through a life-wrapped fund such as Standard Life’s Corporate Bond fund, which invests in abrdn’s Euro Corporate Bond Fund;
– an exchange-traded fund (ETF), such as State Street’s SPDR Bloomberg Euro Government bond ETF, which aims to track the performance of the euro zone government bond market, or;
– a fund sold through a broker, such as JP Morgan’s Emerging Markets Investment Grade Bond fund.
These are just examples, not recommendations.
“It is possible to find accumulating or distributing share classes,” says Geoghegan, depending on whether you want to draw an income or have it rolled up.
So, an accumulating fund will reinvest the annual interest paid out on the bond while a distributing fund will pay that out to investors as the interest falls due. Which one suits you depends on whether you need the income from the investment in the short term.
You never know what the future will bring and how it might affect an investment. That’s why more risk-averse investors can consider money market funds, which can invest in short-duration funds, delivering a higher interest rate than simply leaving the money on deposit in a bank.
How much will it cost?
As with other assets, how much it costs to invest in bonds depends on your choice of investment.
If you buy a fund through a life company, you’ll pay an annual management fee – Standard Life’s Corporate Bond fund, for example, has a 1 per cent annual fee – as well as the insurance levy.
If you buy an ETF bond fund, you’ll have broker fees in addition to a management fee.
And if you buy individual government or corporate bonds, you will also have to go through a broker and incur fees.
Risk profile
Again, it depends on the product you invest in. The most dramatic risk is default – that is, the issuer finds themself unable to repay either the money you have lent them or the interest they promised, or both.
In general, governments are seen as more reliable than companies, which is why they are able to get buyers for their debt at lower interest rates.
And even within a company, there can be a hierarchy of debt, with the company promising some classes of investor priority in terms of repayment should things go sour.
When choosing a bond to invest in, you need to “question the quality of that contract”, says McDonagh, and ask: “What are the chances of that contract not being fulfilled?”
Ratings agencies help in this regard, as bonds typically get a rating from the likes of Standard and Poor’s and Moody’s, ranging from AAA (Ireland is rated just below that, at AA+), indicating exceptional creditworthiness, down to triple C or junk bonds.
The higher the rating, the less the debt issuer is considered a default risk and the lower the interest rate you can expect to receive. With bonds rated triple-B and above, “you’re pretty sure you’re going to get your money back”, says McDonagh.
But there are other risks – and these can be more pertinent if investing in Irish bonds, for example, where the default risk is low.
“It’s not so much about credit risk. Are we worried about Ireland not paying back its bonds? No – it’s about inflation and time risk,” says McDonagh.
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One factor to consider when assessing risks is the impact of inflation over time. If you hold the bond to maturity, you will get what you invested back – but will this be worth what you originally invested?
“It might be worth less than you thought it would have been, due to inflation,” says McDonagh. If you’re getting a coupon of 2.5 per cent for example, but inflation is 3 per cent, “in theory you’re not maintaining your wealth”, says McDonagh.
Interest rates are another factor, especially with longer-dated bonds. With a 30-year bond for example, “you’ve got much greater volatility in the bond if you get a move in interest rates”, says McDonagh.
As Geoghegan notes, if you’re getting 3 per cent today and you hold your bond to maturity, which is tomorrow, and interest rates rise to 4 per cent, your time to maturity is so short that it’s not going to impact you.
But if you have 10 years to maturity, “you’re missing out on that additional 1 per cent compound interest over 10 years”, says Geoghegan. The price of the bond will fall to reflect that loss of compound interest.
Exiting an investment
Typically, a bond investment is highly liquid. You can sell your bond or bond fund through a broker in the normal way. Geoghegan notes, however, that lower rated, less well known bonds can have illiquidity in times of stress.
What tax will I pay?
The good news – at least when it comes to Irish Government bonds – is that you won’t pay tax on your gains.
“It’s beneficial but not necessarily the main reason you’d buy,” says Catriona Coady, head of tax with Goodbody Stockbrokers.
However, interest from Irish Government bonds is liable to income tax, PRSI and USC.
What about overseas corporate or government bonds? Well, if you invest in US treasuries, for example, as with Irish Government debt, interest is liable to income tax, PRSI and USC – and you will pay capital gains tax at 33 per cent on any gain.
If you lose money on the investment, this means they can be offset against capital gains on other investments.
The same is true of corporate bonds. If you opt to invest in a bond fund, on the other hand, you will pay tax at 41 per cent on any gains. If you hold the bond fund investment for eight years, deemed disposal means that 41 per cent is levied against profits to date even though you continue to hold the bond fund.
And if you lose money on a bond fund investment, those losses cannot be offset against gains elsewhere, unlike with capital gains tax.
‘How to Invest’ is a series of articles guiding readers through the basics of investing in different assets. See also: The risks of leaving money on deposit, How to invest in shares and How to invest in a fund. Next week: Commodities