Corporate bonds can offer an attractive level of income
It is universally accepted that the value of anything is influenced by two main factors — supply and demand.
In the past this effect has driven the price of land, gold and oil both up and down again.
It even translates into the art world, which is why an artist’s portfolio often increases in value after their death.
Currently the thing that many people need, and which is in decreasing supply, is income. Interest rates have fallen to unprecedented levels.
Savers relying on returns from deposits will be progressively affected by falling interest rates as deposit rates converge with the base rate, which is currently at 1%.
I have looked at many different income options in this column over the past few weeks, but what if you have corporate bond funds in your portfolio? Corporate bonds currently offer yields of up to 7%, with the prospect of limited capital growth. They can fall in value as well as rise but, as income becomes increasingly valuable, investors should be prepared to pay more.
Bond prices started falling as we entered recession with fears growing about defaults. They have also been driven lower by a wave of forced selling as institutions offloaded assets to raise cash and repair balance sheets.
These same institutions would usually invest in bonds at these prices, but they simply don’t have the capital available. With a surplus of sellers and an absence of buyers, you could argue that now might be a good time to buy.
If you are thinking about your ISA allowance for this year, it is important to remember that both the income and any capital growth from corporate bonds is completely tax free.
And the income can be reinvested to boost the capital growth potential. Please note however that corporate bonds are very different to cash as they could fall in value even from these levels.
Corporate bonds are based on corporate debt. So what are the chances of default? Looking back to the Great Depression of the 1930’s, no more than 5% of bonds defaulted over a five-year period.
Therefore, unless we are facing a recession that is significantly worse than the Great Depression, prices could rise substantially.
But it is important to understand exactly how corporate bonds work. Take this example (noting that it has been radically simplified in order to demonstrate the principles):
Two investors buy an ABC corporate bond that pays interest of £8 a year for 10 years and then returns £100.
Investor A pays £80 for the bond and receives an income of £8 a year for ten years — a yield of 10% on the initial £80 investment. When the company repays the loan they should receive £100 so they also enjoy £20 capital growth.
Investor B buys the same bond some time later, pays £100 for it and receives the same income as Investor A — £8 a year.
But, having paid £100 for the bond, the yield on the initial investment is only 8%. When the bond redeems they too should receive £100 — the same as the price paid — so there is no capital growth.
In summary then: Investor A pays £80 for the same amount of annual income (£8) as Investor B, who pays £100. Investor A also receives a £20 profit if the bond is held to maturity but Investor B makes no profit.
Today many bonds are priced well below £100, offering the prospect of a good yield plus some capital growth. But there are many different types of bond funds and you will need to select the type that best suits your risk appetite and your need for income.
One way of benefiting is via a fund that takes a true ‘total return’ approach. These funds have the flexibility to seek out the optimum balance of risk and reward, whether that is in higher-risk high-yield bonds, investment grade bonds or gilts.
Like all bond funds they offer an attractive level income, but they can also make the most of the capital growth opportunities.
Nicholas Watts is an independent financial adviser with Positive Solutions Financial Services which is regulated by the Financial Services Authority. To contact him, use the website www.realwealthmanagers.co.uk