The pros and cons of fixed income investments
Investors seeking to generate an income may turn to fixed income investments. Here, we examine the outlook for the asset class, alongside its benefits and drawbacks.
What you’ll learn:Click to toggle accordion What you’ll learn:
How fixed income investments work.
What the main advantages and disadvantages are.
How to add fixed income to your portfolio.
Fixed-income investments are often a popular choice among investors hoping to generate steady returns, especially when even the highest paying savings accounts are failing to keep pace with the cost of living.
The fixed income asset class enjoyed a record year in 2017, with net sales of £14.3 billion, outstripping all other assets, according to the Investment Association.1 However, the asset class has been knocked off the top spot over recent months, as investor appetite for fixed income may be waning amid some uncertainty over the outlook for these investments.2
How fixed income investments work
Fixed income investments focus on providing a reliable stream of income. The most common fixed income investments are usually bonds, which are fixed term loans issued by companies and governments looking to raise money. UK government bonds are called Gilts, whilst in the US government bonds are known as Treasury Bills, or T-Bills, and German federal bonds are referred to as Bunds.
A bond issuer will pay investors a fixed rate of interest for a set period, at the end of which the loan is repaid. If you buy a bond when it is first issued, when it matures you should get your money back in full, but bear in mind that when investing in individual bonds, the particular issuer promises to repay your investment on maturity, but it may fail to do so in the case of insolvency, so you could lose money. Investing in individual bonds can be particularly risky, as their fortunes rely on the specific issuer, whether a corporation or government.
As a result, many investors opt to put their money into bond funds, as these can help spread risk by investing in a wide range of bonds. Some bond funds will invest solely in a basket of bonds issued by companies, while others will focus purely on government bonds, and some will invest in a combination of these. As with all investments the rule of thumb is that the higher the potential return on offer, the riskier the investment. Bonds which are rated from AAA down to BBB by credit ratings agencies such as Standard & Poor’s or Moody’s are classified as ‘investment grade’ and are deemed to be lower risk.
Generally, fixed-income investments are considered less risky than equities, with income from bonds being paid out before any dividends on stocks, and bond payouts taking priority over shareholders in the case of insolvency.
Bonds can usually be sold before their maturity date but their market value will change over time, and may be affected by any fear of a government failing to repay or a particular issuer facing financial difficulties. The perception of the issuer’s ability to pay will reduce the value of the bond, which is also impacted by credit agency assessments and ratings. This means that when you sell your investment in the market you may get back less than you originally put in. The value of a bond will also be affected by changes in general interest rates – see below.
Outlook for fixed income
The past few months have perfectly showcased the pros and cons of the bond market in the current economic and political backdrop, according to Will Hobbs, head of investment strategy at Barclays Wealth & Investments.
He said: “On the one hand, a world economy less in need of emergency monetary care is exerting upwards pressure on interest rates, which is potentially bad news for bonds. On the other hand, returning fears of trade wars and even another euro crisis have burnished the safe haven appeal of an asset class that tends to outperform when the economic and political skies darken.”
A sustained rise in the Bank of England’s base interest rate could have an impact on the value of bonds. Higher interest rates typically reduce the value of existing bonds that carry lower rates, since the new bonds will be issued paying higher returns and hence will be more attractive. This weakens demand for lower-interest bonds. Lower interest rates, however, push up the value of existing bonds, because returns from them can be more attractive than existing bonds and those offered by cash accounts. The Bank of England has said that interest rate rises are likely in the months ahead, to dampen the impact of a stronger global economy on UK inflation. This follows a series of rate rises by the US Federal Reserve, with more expected.3
Will Hobbs said: “The world has long been ready for higher interest rates. However, the pace of that correction remains key to the impact on the fixed income asset class. While inflationary forces gather, central bankers likely have the space to let the air out of fixed income assets slowly.
“Yet, unless there’s a full-blown trade war or other economic shock, we see the fixed income asset class offering diversification rather than return appeal at present.”
Whatever the future holds, there will always be some risk to investing within the asset class, like any other investment. A bond issuer, for example, could fail to meet its interest payments or repay your capital if it gets into financial trouble, or a government may simply fail to pay. If they do you will not get your income payments from investing in the bonds, and might not get your capital returned on maturity.
How to invest
If you’ve decided you want to invest in gilts or company bonds, you can do this directly via Smart Investor.
Whilst you can invest in Gilts in small quantities, corporate bonds often have higher minimum investment amounts and are generally traded in multiples of 1,000 which can make it harder to invest unless you are investing significant sums.
While the interest rate offered by corporate bonds will typically be higher than gilts, it’s important to remember that that they come with more risk, given that a company is more likely to default on payments than the UK government. It’s therefore essential to thoroughly research the underlying company before investing.
Building a diversified portfolio of bonds and gilts can also be expensive if choosing individual investments. Because of this many investors choose to invest via a bond fund, which will hold a wide variety of fixed income assets to help spread risk.
Bear in mind that how much exposure you want to fixed income will depend on what you expect to happen to interest rates and the economy, but if you’re unsure, you should seek professional financial advice.
Options for investors wanting to put their money into investment grade bonds include Fidelity’s Moneybuilder Income fund (ISIN: GB0003863916) and Invesco Perpetual’s Corporate Bond fund (ISIN: GB0033050690).
Investors who are prepared that they may lose money with exposure to high yield and emerging market bonds, may decide to consider Jupiter’s Strategic Bond fund (ISIN: GB00B544HM32). This sits in the Investment Association’s Sterling Strategic Bond asset class and aims to achieve a high income with the prospect of capital growth by seeking out the best opportunities within the fixed interest universe globally.
Please bear in mind that our mentioning these particular funds does not constitute advice or a personal recommendation. Remember that the value of bonds, like all investments, can fall as well as rise. If you’re unsure where to invest, please seek professional financial advice.
Remember, the value of investments can fall as well as rise and you could get back less than you invest. We're not recommending Ready-made Investments as being suitable for you based on your personal circumstances. If you're unsure about this investment’s suitability for you, you should seek independent advice. Tax rules can change in future. Their effects on you will depend on your individual circumstances.
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