Understandably these developments have led many investors to become increasingly wary of the equity markets and, despite the new year rebound, many have been keen to de-risk their portfolios and switch to fixed income securities.
The fixed income markets give investors a wide range of options, depending on the scale of their investment and their appetite for risk. The main risks related to fixed income investing are interest rate risk and credit risk, which can be assessed in terms of duration and credit spread respectively.
The duration of a bond is similar to its maturity, but more precisely duration is a measure of the weighted average life in years of a bond’s interest and redemption payments. It is a very useful metric for assessing risk and return profile.
If the portfolio of a bond fund has a duration of five years, a 1% increase in the interest rate at the five year point of the yield curve will result in a 5% decrease in the value of the portfolio.
Credit spread is measured in terms of the difference between the yield of a corporate bond and the yield of a comparable government bond.
The higher the probability of default the higher this difference will be. If, for example, the average credit spread is 3% pa it can be expected that credit losses in a portfolio will average 3% pa.
With the concepts of duration and credit spreads in mind, investors can assess which fixed income investments meet their investment criteria in particular market circumstances.
Government bonds – limited risk, limited reward
Currently the sterling yield curve is very flat out to five years where yields are just under 1% pa. This means that investors are not being rewarded for taking duration risk. Investors who fear that interest rates might rise should be cautious about investing in longer dated gilts. Yields on 10-year UK gilts over the past two years have averaged 1.3%. UK inflation has not helped, running as it has at above 2% for the past two years, making it very difficult for gilts to offer real returns to investors.
Retail bond market – higher yields, but a lack of liquidity
Retail bonds have become extremely popular in the past five years. After the 2008 financial crisis the retail bond market emerged as a popular tool for both companies and investors. Following the launch of the electronic-driven Order Book for Retail Bonds by the London Stock Exchange in 2010, the retail bond market grew exponentially from £100m to £2bn in just two years. For a while, it became possible for investors to build a laddered portfolio of bonds with different maturities that made the management of duration and credit risk much easier. Unfortunately, the market has faced competition from credit funds and challenger banks and the number of new issues has declined.
P2P lending – even higher yields, but buyer beware
The hunt for yield has become a preoccupation of investors in an era of low interest rates with many turning to Peer2Peer (P2P) lending. P2P lenders, on average, offer annual returns of up to 7% while some P2P platforms offer returns into the double digits. While these returns may be attractive to investors, they do imply high risk. Investors should check the default rate of each platform and ask about the debt recovery process that follows a default. Fundamentally P2P lending offers efficiency in the investing process through technology. It does not reduce the requirement for investors to be vigilant. The FCA is proposing tighter regulation of P2P platforms. It is consulting about several new regulatory requirements ranging from P2P lenders having to publicly disclose their actual rates of return, default rates, and loan risk and duration, to restricting the amount investors can place with a P2P platform to no more than 10% of their net investable portfolio.
Debt funds – a balance of risk and reward
There are a variety of debt funds that cover the credit spectrum from government bonds to P2P lending. Those investing in traded bonds may be open-ended, while more diverse or specialist funds tend to be investment trusts or limited partnerships. Management fees reduce investment returns, but the funds offer the benefits of diversification, management expertise and easier tax reporting.
We have advised our own SME debt fund since its launch in 2016 where we use a laddered portfolio approach. It now has a consistent track record, with the fund generating a return of 6.2% over the past 12 months.
As is clear from the wide range of options above, there are many routes for investors to play the fixed income markets and carefully assessing each before investing should help them generate the most robust returns.
Simone Westerhuis, is managing director of LGB Investments