Investors find themselves in an unenviable position at the moment. There was a time when the best protection against the danger of the stock market was a diversified portfolio that balanced high-risk investments with the old, blue-chip reliables. In Ireland, that generally meant holding banking shares which, as we all know, turned out to be not so reliable after all. So where to now for the conservative, risk-averse investor?
Cash deposits seem the obvious answer, but more cuts in the ECB interest rate will reduce returns over the coming year. There are some attractive fixed-rate long-term deposit accounts at the moment, but analysts expect rates to fall in line with the ECB in the future. Equities are way too volatile at the moment. Property is falling fast. If you are looking for a safer option, bonds may be the way to go.
When you buy a bond, whether it is for a company or government, you are basically lending money to that institution which they promise to pay back on a fixed date in the future. Over the course of this 'loan' the bondholder is also entitled to a series of 'interest' payments – known as coupons – at a fixed rate. Bonds are also sold on a secondary market, where the value of the bond can rise and fall depending on economic circumstances. Income from both corporate and government bonds is subject to the marginal rate of income tax and any profit made from the sale of a corporate bond is subject to capital gains tax at 22%.
Not all bonds are created equal. Governments issue bonds to pay for large-scale projects or to finance tax cuts. The Irish government recently issued a bond to raise €6bn with a yield of 4.7% on maturity in 2014, for instance. They are considered a safer bet because, when the time comes to repay the original sum, taxes can be raised or spending cut to meet the cost. It is rare for a government to default on a bond, and the IMF will step in to prevent this happening.
Corporate bonds, on the other hand, are a riskier proposition. Companies issue bonds to raise capital that they cannot get from a bank. The main risk is that the company will close and the loan will not be repaid – Woolworth's bondholders are still licking their wounds after the company's collapse last year.
Oliver Gilvarry, head of research at Dolmen Stockbrokers, says Dolmen is advising clients to scale down their exposure to equities considerably by diversifying their portfolio to include 45% government and corporate bonds. Before the credit crunch, most portfolios would have been 90% equities, with some shares chosen expressly for their annual dividend. This is simply not happening any more, Gilvarry says.
"What we are seeing is weaker companies cutting dividends to retain cash and stronger companies actually making purchases and then cutting dividends to support that. There is no stigma attached to cutting dividends at the moment: people are expecting it. If you are looking for yield, corporate or government bonds are the way to go," he says.
The climate is favourable to bondholders – inflation is low so the value of bonds is keeping steady, and interest rates are falling, so they are investing in something with a guaranteed return that may be higher than deposit. And with the banks continuing to tighten the screws on giving credit, companies are turning to bonds to raise more capital and are offering those bonds at attractive rates to bring in wary investors.
"There is a lot of volatility out there. With banks not lending as much, corporates are issuing bonds. That had tailed off because of the availability of funding from banks in recent years. What we are seeing is attractive yields coming out because corporates still have to fund themselves and there are good corporates out there," says Gilvarry.
Dolmen's most recent weekly bond report highlighted bonds from institutions as diverse as the Irish government, McDonald's, Bank of Ireland and GlaxoSmithKline.
Becoming a bondholder for a specific company is done via a stockbroker. However, it is a realistic prospect only if you are in a position to invest a substantial amount of money – somewhere in the region of €50,000 or above. That does not mean the smaller investor looking for something a little bit more conservative than equities cannot access bonds. If you have a smaller lump sum to invest, you should consider investing in a bond-based fund like Standard Life's Euro Corporate Fund or the Robeco High Yield Bonds Fund (through Rabodirect).
It should be noted that, as with all investments, the value can rise or fall depending on the market. When considering investing in a fund it is vital that you look at the make-up of the bonds involved. With many companies edging closer to the wall, it is probably wise to look for a fund with a higher than average percentage of low-risk bonds, including government bonds and corporate bonds issued by companies that are highly rated.
Paul Smyth, investment director with Standard Life, says it is concentrating on substantially higher-rated corporate bonds to safeguard against the volatile business environment.
"It is very important to note that quality investment-grade corporate bond funds are a less risky animal than high-yield corporate bond funds… Continued worries on the global economy lead us to believe it is too early to venture into higher-risk corporate bonds as default risk within this sector remains relatively high," he says.
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