The benefits of bonds: a fixed income alternative to equities

By Mateusz Malek

July 2023

Bonds offer a fixed income and can deliver attractive returns over the medium to long term, making them an excellent investment to consider for your portfolio.

Bonds offer some advantages over equities. These include providing a regular income, aiding with portfolio diversification, and typically experiencing less volatility. However, as with all investments, you should consider the nature of the security and any associated risks before buying bonds.

In this blog post we will answer the questions that we are most frequently asked about the benefits and risks associated with bonds and explain how we use them for investment on behalf of our clients.

Please note: As is the nature with all investing, your capital is at risk, and you may not receive back the same amount as you put in when you choose to cash out your savings.

What is a bond?

A bond is a debt security issued by a government, company or other entity seeking to raise money from investors, typically to finance and/or expand its operations.

A bond may also be referred to as a fixed income security as it will provide investors with a stream of fixed periodic interest payments and the return of their capital at maturity. Investors also know in advance the payments and maturity profile of a fixed income security.

Finally, “gilts” is a term that refers specifically to UK Government Bonds issued by the UK Debt Management Office (DMO) on behalf of the UK Treasury to raise finance for public spending.

Please note: the bonds that we buy are tradable securities that may not be publicly accessible to all investors. This is a different type of bond to those offered by banks, which simply function as deposits with a fixed-term agreement for payment of interest.

How do bonds work?

Selling a bond establishes a contract between the issuer and the buyer whereby that issuer agrees to pay the bond holder an annual coupon for the duration of the bond and to repay any principal at the specified maturity date.

Although bonds are typically issued at or around their face value, they are tradable securities, and their prices fluctuate between issuance and the maturity date. Because an investor can buy a bond in the secondary market at a different price to the bond’s face value, they need to be able to assess the bond’s expected rate of return. This is where the yield comes in.

A bond’s yield to maturity (also known as the gross redemption yield) is a measure of the bond’s total annual rate of return. This takes into account both income received, in the form of coupons, and any capital gain or loss from holding the bond to maturity.

Note, that a bond price and a bond yield have an inverse relationship, when one goes up, the other goes down. The sensitivity of this relationship can be measured by duration. Bonds with high duration will experience higher price volatility when yields fluctuate than the bonds that have short duration.

The tables below illustrate in simple terms how we might manage bond portfolios across different scenarios.

Scenario One

Interest Rates Low
Bond yields Low
Bond Prices High
Corporate Spreads* Tight

Recommended approach: Due to historically low yields and tight corporate spreads, we would focus on shorter-dated and higher quality bonds to shelter portfolios from potential future rate increases and/or spreads widening.

* A measure of additional compensation offered by corporate bonds over similar-maturity government bonds

Scenario Two

Interest Rates High
Bond yields High
Bond Prices Low
Corporate Spreads* Above historic averages

Recommended approach: In such a scenario, we would be looking to increase portfolio durations to lock into higher yields for longer. This may present an opportunity to generate attractive income from a portfolio of good quality bonds for longer and offers the potential to generate excess returns should yields fall in the future.

* A measure of additional compensation offered by corporate bonds over similar-maturity government bonds

For a more detailed introduction to how bonds work, check out our dedicated Killik Explains playlist.

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What are the benefits associated with buying bonds?

The main benefit of bonds is that they generate a predictable level of income, thereby offering investors complete visibility over the timing and amounts of any coupon payments and principal repayment at maturity**.

Their higher predictability of returns, combined with the fact that they typically rank higher in the capital structure than equity, means that bonds tend to be less volatile than many other asset classes, including shares.

In addition, bond issuers are contractually obliged to pay coupons on debt securities before passing on any profits to shareholders, which creates a more stable and predictable income stream than most other asset classes.

Bonds may also appeal to those looking to diversify a larger portfolio comprising other asset classes, such as equities.

In some circumstances bond investors can also benefit from a favourable tax treatment, as many sterling denominated bonds are classified as ‘qualifying’ making them exempt from Capital Gains Tax (CGT). Further, most bonds will also be eligible for inclusion in an Individual Savings Account (ISA) and a Self-Invested Personal Pension (SIPP)***.

What are the risks associated with buying bonds?

As is the nature of investing, there are risks involved when investing in bonds.

Firstly, there is the risk that an issuer may default and as a consequence you may get back less than you invested, or lose your initial investment altogether. Next, bonds are negotiable and consequently prices as well as yields, can fluctuate between issue and redemption. There are a number of factors that could affect the yields and prices of bonds, for example, the level of inflation, length of time until maturity, issuer’s financial position and movements in interest rates.

Meanwhile, for some bonds, secondary market liquidity may be thin, so the spread between the selling (bid) and buying (offer) price may be wide and there may be occasions where it is not possible to immediately sell a bond to protect against falling prices.

Finally, unlike a bank or building society deposit, a corporate bond is not covered by the Financial Services Compensation Scheme (FSCS).

How we monitor and manage bonds

Our Fixed Income investment process consists of the following stages:

      1. An assessment of the macroeconomic environment. Bonds are heavily influenced by changes in interest rates and inflation expectations. These can be impacted by all manner of things including the prevailing economic conditions, government fiscal policy and central bank monetary policy, all of which are considered when putting together bond portfolios.
      1. An analysis of the credit strength of a bond’s issuer. Credit analysis can be broadly split into an assessment of two types of risk:
      • Business risks – a largely qualitative assessment of a company’s business profile, including the quality of management, the company’s scale, its competitive position, the barriers to entry and the cyclicality of the business.
      • Financial risks – a more quantitative assessment of a company’s leverage, liquidity position, cash generating capacity and profitability.
      1. Relative value assessment. Finally, we consider whether the value offered by the bond (i.e., its yield and credit spread) is commensurate with the company’s credit strength and the maturity and structure of the bond.

To learn more about how we can help you build a diversified portfolio that takes advantage of the benefits of bonds and other asset classes, please speak to an Adviser.

** As is the nature with all investing, your capital is at risk and you may not receive back the same amount as you put in when you choose to cash out your savings.

*** Please note, the tax treatment depends on the individual circumstances of each client and may be subject to change in the future.