Fixed income investing explained

Apr 5, 2023 | Investment Advice

By Canaccord Genuity Wealth Management.

IOM Investment Management

Do you get confused when it comes to the different types of investments that make up your investment portfolio? Are you wondering about the benefits and drawbacks of the potentially ‘safer’ and ‘steadier’ style of fixed interest or fixed income investing in today’s uncertain investment climate?

Here, we explain what we mean by fixed interest or fixed income investing in bonds, what it is, who it’s for and how we invest in fixed interest assets or bonds at Canaccord Genuity Wealth Management (CGWM).

What is fixed income investing?

Fixed income investing – often referred to as investing in bonds – provides a fixed amount of annual income for the investor, which is usually a fixed percentage of the nominal amount purchased. The largest sector of the fixed income market is made up of bonds issued either by governments (‘gilts’ or US Treasury Bonds) or by companies (corporate bonds).

In a typical diversified investment portfolio, an investor would have exposure to the main asset classes: equities, bonds, alternative investments and cash.

Who chooses fixed income investing?

Investors who place large portions of their portfolio in fixed income investments are usually looking for a regular, stable income stream. They are often retired and reliant on their investments or pension to provide a monthly income.

Why invest in fixed interest or fixed income investments?

  1. To diversify your portfolio to reduce the volatility of returns (and thereby the risk) by investing across different asset classes
  2. To generate a steady income stream
  3. To produce capital gains (potentially)
  4. For a more certain return of capital
  5. To use the fixed annual income to offset fixed liabilities.

What types of fixed interest bonds should I invest in?

When investing in fixed interest bonds, it is a mistake to view all types of bonds in the same way. The risk, return and role they play in your portfolio can vary greatly, depending on the characteristics of the bond and the reason you originally chose it.

For example, some bonds are considered high quality (lower risk – lower return) – such as bonds issued by governments or blue-chip companies (known as investment-grade bonds). Other bonds are regarded as lower quality (higher risk – higher return) such as bonds issued by companies whose ability to pay interest and repay the capital at maturity is less reliable (sub-investment grade or high yield bonds).

How long is a bond’s ‘lifetime’?

Fixed interest investments are basically loans or ‘debt’ instruments which typically have a specified duration before they are redeemed. This can be anything from one month up to 30 years. During that lifetime they usually pay a set amount of annual income to you – the ‘coupon’.

Why are bonds generally considered lower risk?

Bonds usually rank higher than equities on a company’s balance sheet and, in case of liquidation, the recovery potential for a bond investor is greater than for an equity investor.

The performance of bonds also tends to have historically a low correlation to equity returns. This means that fixed interest investments help to diversify your portfolio.

How are fixed income bonds rated?

Being debt instruments, bonds are risk rated by their ‘credit rating’. They are rated from AAA (highest) to D (lowest). Investment-grade bonds, the higher-quality fixed interest investments, are rated from AAA to BBB, while sub-investment grade (higher yield) are rated BB to D.

What can affect the price of bonds?

The three main factors affecting the price of bonds are:

  1. Interest rate risk – The direction interest rates are moving
  2. Credit risk – The perceived risk associated with the issuer
  3. Duration risk – The amount of time left before the issuer must repay the bond holder

Shorter-dated bonds – those that will redeem within five years – are less price sensitive to interest rate movements than longer-dated bonds. This means prices tend to move up or down less when interest rates rise or fall.

What is the difference between higher- and lower-quality bonds?

Higher-quality bonds are more interest-rate sensitive and will decline in price as interest rates rise. Lower-quality bonds tend to be less interest-rate sensitive and more sensitive to the economic climate. If times are prosperous, they are more able to make interest payments and repay bond holders when the bond reaches its maturity date.

How do we approach fixed income investing?

There are various ways to generate fixed income from your investment portfolio. As we have deep expertise and experience in fixed income investing and can access a wide range of bonds and gilts directly or via funds, we can use different approaches based on your individual income requirements:

  • Bond ladders: A portfolio of bonds maturing regularly, for instance from two to 12 years; as the shorter-dated bonds redeem, proceeds are reinvested longer term
  • Cash flow modelling: A portfolio of bonds providing regular income and certainty of capital return aligned to your schedule of known monthly outgoings; this allows you to manage your annual income needs
  • Discount investing/grossing up return: Investing in deeply ‘discounted to par’ corporate bonds or gilts, where a large part of the total yield to redemption is capital gain (which is generally tax free for most UK individuals investing in qualifying corporate bonds).

For example, the UK Treasury Gilt 0.125% with a maturity date of 31 January 2024 is trading at £96.65 and will yield c.3.77%; or the UK Treasury Gilt 0.25% to be redeemed on 31 January 2025 is trading at £93.50 and will yield c.3.75%.

Are there any tax advantages to fixed income investing in bonds or gilts?

Yes, there are. While interest payments are subject to income tax, both ‘qualifying’ corporate bonds and gilts are free of capital gains tax for UK individual investors, although we would always advise you to check with your tax adviser about your specific situation. This means that bonds can also provide a useful tax-mitigation role as part of a diversified investment portfolio.

Why invest in bonds right now?

In early 2023 bond strategies are more attractive than they have been for several years for two main reasons. First, the current yield available; and second, the potential return due to the outlook for interest rates.

A year ago, an investment grade sterling corporate bond portfolio might have been yielding on average 3.75%. The same portfolio is now yielding c.5.50%. This is because interest rate rises over the past 12 months caused a dramatic c.22% drop in bond prices (price goes down, yield goes up) – and expectations are that rates will now stabilise with a drop in the rate of inflation and may even be cut if there is a severe recession. Bond prices have already recovered c.10% in the last 3 months.

This means that if you hold the bond to maturity, your annual return will equate to c.5.50% pa, so bonds now offer a real alternative to equities and other asset classes.

However, your potential return is not limited to 5.50% pa until redemption of the bond. If we have a recession, which looks more and more likely, there is a strong chance that interest rates will need to be reduced to stimulate the economy. While bond yields will fall nominally, you could then see a capital uplift.

As an example, take the Rothesay Life 5.50% GBP 2029. It is rated BBB and currently priced at £98.50, yielding 6.55%. If it goes back to yielding 5%, this would imply a price of c.£115, which is a meaningful 16% price increase. Even if this does not happen, you could just hold the bond to maturity and make c.6.55% pa from here to 2029, subject to the risks mentioned below.

What are the risks associated with investing in bonds?

As well as the current economic and interest rate outlook, there is a risk that the corporate bond issuer is not creditworthy and that they might default on their bond payments – either they cannot afford to pay you the fixed income/coupon, or they cannot afford to repay your capital on maturity.

CGWM sets out to find bonds we think offer value but, more importantly, are ‘money good’, which means we believe the company is sound enough to service its debt and repay investors on redemption. They should be issued by companies that can operate in the prevailing economic conditions and have a healthy balance sheet. Depending on what is happening in markets, it’s important we adjust our strategy accordingly. We look at several factors including global macro-economic fundamentals, the direction of interest rates, and thematic ideas and geographies.

Investment in bonds involves risk. The value of your bond investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.  Specific risks include: the coupon level; company default; inflation and entry price.

The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.

This is not a recommendation to invest or disinvest in any of the companies, themes or sectors mentioned. They are included for illustrative purposes only.

The information contained herein is based on materials and sources deemed to be reliable; however, Canaccord Genuity Wealth Management makes no representation or warranty, either express or implied, to the accuracy, completeness or reliability of this information. Canaccord is not liable for the content and accuracy of the opinions and information provided by external contributors. All stated opinions and estimates in this article are subject to change without notice and Canaccord Genuity Wealth Management is under no obligation to update the information.

The tax treatment of all investments depends upon individual circumstances and the levels and basis of taxation may change in the future. Investors should discuss their financial arrangements with their own tax adviser before investing.