Investing in bonds: what are the risks I need to consider?

June 9, 2015

Investing can seem like something only rich people do. It appears to be complex, daunting and very risky. In actual fact, you’re probably already an investor (and you just don’t know it), and it doesn’t have to be risky, scary or daunting. It can actually be pretty straightforward. We’ve already covered stocks, so let’s take a look at another main ‘asset class’ that you can buy on the Stock Market: bonds and gilts, also known as Fixed Interest assets.

What are bonds?

Bonds, or fixed interest assets, are essentially a form of debt. The twist is that in this scenario, you are the bank. You loan the money to an entity (most likely a big company or a Government) for a set period of time and they promise to pay you back in full, with some interest on top. That interest could be fixed or variable, depending on the bond that you choose. Bonds also have different ratings depending on how ‘secure’ they are. If there is any doubt that an issuer will be able to make good on their payments, you may get a higher interest rate – a touch more risk for a potentially better return. At the other end of the scale are things like UK Government bonds, where the Treasury writes you an IOU – chances are you’ll get your money back on those (unless the UK Government goes bust, that is)…. Here in the UK, Government bonds are called Gilts.

People traditionally access fixed interest assets (bonds and gilts) via fixed interest collective funds, where the fund manager actively trades in the bonds. It is possible to buy these direct but, unlike equities, you generally need large amounts of capital to do this and make it worthwhile.

Why would you invest in a bond?

A broad way of thinking about it would be equities (shares) are seen as relatively risky as they are exposed to the ups and downs of the Stock Market, while fixed interest assets are generally less risky because they are not. Let’s look at an example, using some rough percentages to help, and focusing on a typical ‘lifestyle’ pension product.

Let’s say you’re 25 and you start investing in your company pension. You get a form which asks you to say what kind of investor you are, and like most people, you tick the middle box. So, as a ‘balanced’ investor, your money would be split into several different pots, but broadly it’s split into equity products and fixed interest assets. As you’re only 25, you’ll have a larger percentage of equities making up your pension. Let’s say you start out with 60% invested in equities while 40% is invested in fixed interest assets. The logic here is that 60% of your money would be exposed to the greater fluctuations of the Stock Market (with its potentially higher returns) while 40% of your money earns less overall, but the amount it earns is more stable.

Make sense so far? As you get closer to your retirement date, your lifestyle pension would automatically start selling a percentage of your equities to buy more fixed interest assets. Why? Well, when you were younger, you had more time to recover from Stock Market crashes. As you approach retirement, it would be harder to recover, so your pot is ‘rebalanced’ to make it more secure. Perhaps when you’re 50, you’ll have 40% in equities and 60% in fixed interest assets, and when you’re only a few years off retirement, your pot will be heavily weighted towards bonds to make the money that you’ve saved over the years more secure (theoretically!).

So in short, fixed interest assets help you offset the risk of having all of your money invested in equities in the Stock Market. Yes, you’re sacrificing potentially higher returns, but you’re also protecting yourself against potentially higher losses and you’re (virtually) guaranteed to get your money back – especially with a Government bond.

Wait, I should have sensed a ‘but’ by now…

Sorry if we didn’t make that clear enough. Of course there’s a ‘but!’ We clearly need to work on our cliffhangers.

The main ‘but’ is that you can’t assume that just because you buy fixed interest assets you have a low-risk investment. Bonds and gilts aren’t always that straightforward, and involve ‘interest-rate risk’ (where the risk is that interest rates will rise meaning that bonds issued when rates were lower are worth less) and ‘credit risk’ (which is the risk that the issuer might go kaput).

With interest rate risk, the longer you buy a fixed interest asset for, the more risk there is. You also have to consider that if you buy bonds which are bundled into funds, then the low returns relative to stock funds means that fees and expenses will take a bigger slice of your pie. We’ve talked about the impact fees can have on your pension before, but with fixed interest asset funds, you need to really focus on them.

One last thing to consider is that fixed interest assets, just like regular shares, can be bought and sold. That means that their price can go up and down, which in turn means that you more you pay the less you earn in interest.

So should I buy some bonds?

As always, this is a question that only you can answer once you’ve done enough research or taken some financial advice. If you’re planning on investing in the Stock Market, it makes sense to have a combination of stocks and fixed interest assets. Government bonds tend to hold their value or even go up when share prices fall, and they also pay you an income. If share prices do take a tumble, these two factors would help reduce the overall impact of the drop. And then there’s your current age. If you will be investing over a 40 year period, you may be able to afford to ride out more of the ups and downs of the Stock Market, so perhaps you’ll opt for less fixed interest assets in your portfolio. If you’re retiring in a few years, then the increased security that bonds and gilts offer may well be attractive.

 

This article is for general use only and is not intended to address your particular requirements. It should not be relied upon in its entirety and shall not be deemed to be or constitute advice.

The value of investments can fall as well as rise. You may not get back what you invest.

GreenSky Wealth Limited is authorised and regulated by the Financial Conduct Authority. FCA No. 629624. Registered Office as above. Registered in England and Wales, Company No. 07103441.

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