Wednesday, 13 April 2011

6 Reasons to Include Bonds in Your Portfolio

The DIY Income Investor approach suggests owning bonds - both bonds issued by governments and by banks and other companies - in the following ways:
  • Exchange Traded Funds (ETF) tracking government or corporate bonds : Level 4 of the Income Pyramid
  • Directly-held government bonds: Level 5
  • Directly-held corporate bonds:  Level 7
What are the benefits of holding bonds?


There are 6 good reasons why every portfolio should include some bonds (based on the article 'Why every portfolio should contain bonds' on the Fixed Income Investor site):
  • 1) Diversification:  A well-managed portfolio should contain a variety of different assets classes, including equities, government bonds, corporate bonds, as well as property and alternative assets. This simple approach - not keeping all your eggs in one basket - is one of the most effective strategies for reducing risk in a portfolio. In many economic scenarios, such as a recession, bonds will generally show an inverse correlation in price movements to equities. 

  • 2) Good source of income: Income available from bonds is generally higher than that available from equities. Also, future income payments are a known quantity, unlike dividends from equities, which may be reduced or withheld entirely in times of low profitability. This makes bonds ideal for investors who wish to secure future income over a defined period of time. With bonds paying annually, semi-annually or sometimes quarterly, a carefully chosen bond portfolio with six or more holding can produce a reliable monthly income.
  • 3) Security
    • Government bonds: The risk of the UK or other major governments being unable to repay their debts is low and government bonds can be considered as safe (or safer - for larger amounts of money) compared to a bank deposit. High-grade multi-national government agencies (such as the World Bank) also offer an extremely safe home for the investor holding bonds to maturity.
    • Corporate bonds: Corporate bonds are issued by banks, companies and other organisations. Although the ultimate safety of these investments is not as assured as for government bonds, corporate bonds can be considered a safer investment than the company’s equity - in the event of bankruptcy, bondholders are ranked above shareholders in their claim on the company’s assets.
  • 4) Guaranteed return of capital (usually). Bonds differ from equities in that the redemption date is fixed in advance, meaning that you are not dependent on market sentiment to recover your capital sum - provided you can wait until the date. With shares, you are subject to the uncertainties of future market sentiment or liquidity if you want to recover your capital by selling the security. Some bonds are 'perpetual', however.
  • 5) Ability to avoid tax: Most bonds pay their coupons gross, without withholding tax, whereas dividends on shares are subject (in the UK) to 10% tax, even if held in an ISA. UK gilts are also exempt from Capital Gains Tax
  • 6) As a 'hedge' against falling interest rates: When you buy a fixed-coupon bond, you lock in the yield - potentially for the life of the bond. If wider interest rates fall you be assured of continued good income stream, plus the market value of the bond will rise - giving you the option of either keeping the income or cashing in on the capital growth. This may be useful if your cash savings are generating less income due to the lower interest rates.

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

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