FOOL SCHOOL
Bonds And Gilts - Part III

October 14, 2005

In Part I we looked at the main types of bond and in Part II we looked at how bonds are valued. Here we conclude the series with a look at credit ratings and how you can and whether you should invest in bonds.

Credit ratings

One way of assessing how risky a bond is by looking at its credit rating. These ratings are supplied by a number of credit rating agencies, the most well-known being Standard & Poor's and Moody's. The higher the company's credit rating, the more secure its bonds are believed to be. Investors will therefore be prepared to accept a lower rate of interest for bonds with high credit ratings because the risk that the company will default (i.e. not pay the interest or principal) is much lower.

Credit rating agencies review their ratings on a regular basis and may upgrade or downgrade a company's status if they think its financial situation has changed significantly. A downgrade will usually see the price of a bond fall and its yield rise while an upgrade will have the opposite effect.

The table below summarises the ratings given by the two main agencies. As you go down the table, the ratings reflect an increasing risk that the company will default.

	S&P	Moody's
Investment grade	AAA	Aaa
	AA	Aa
	A	A
	BBB	Baa
Non-investment grade	BB	Ba
	B	B
	Caa	CCC
	Ca	CC
	C	R

The highest group of ratings are collectively known as investment grade bonds. Here the risk of default is quite small. Moody's estimates that less than 1% of top-rated bonds (i.e. Aaa) will default within the following 10 years. With Baa-graded bonds, the default risk is reckoned to be almost 5% over the next 10 years.

For non-investment grade bonds, the risk of default is considerable. For example, with B-rated bonds the chance of default over the following 10 years is thought to be around 45%, or almost 1 in 2.

Investing in bonds

Up until the 1950s, most major investors, like pension funds, preferred to invest in bonds rather than shares, as the latter were thought to be too speculative. However, the high inflation rates seen in the 1960s, 1970s and 1980s and the emergence of what is known as 'the cult of equity' turned this thinking on its head.

Investors cottoned onto the fact that shares tended to provide better returns over long periods of time, although their returns where more volatile from one year to the next. Shares also tend to offer better protection against high rates of inflation. Because the payments from bonds are fixed in advance, their value is quickly eroded by inflation.

Over the long term, this is how gilts have performed against shares and cash. The table below shows average annual returns from 1918-2003.

Type of asset	Nominal return	Real return
Shares	11.4%	7.3%
Gilts	6.1%	2.3%
Cash	5.4%	1.6%

So the returns from gilts have only beaten cash by a small margin while both gilts and cash trail shares by a significant amount. Over the short term, it can be quite a different story. For example, in the five-year period from 1997 to 2002, gilts returned 8.5% a year while shares lost 2% on average.

Many people believe it makes sense to invest a proportion of your portfolio in bonds, to provide some protection against the volatility of shares. One rule of thumb that is quoted on a regular basis is that an individual should have the same percentage of their portfolio invested in bonds as their age. So a 40-year old should have 40% in bonds, a 50-year old 50% and so on. Such guidelines are crude at best though, as they don't account for an individual's attitude to risk. For example, an investor who expects to be able to invest significant sums in the future can afford to be more aggressive with their investments.

At the Motley Fool, we're not huge fans of bonds as long-term investments. If you want to reduce the risk of your portfolio, you can achieve a similar effect by holding a mixture of shares and cash.

You can buy gilts and bonds through most stockbrokers, just like you can buy shares. In addition, you can also buy gilts from the Bank of England. Many investors don't buy and sell bonds directly like this though and prefer to invest in bond funds.

Bond funds

Bond funds can come with a variety of different names, but generally you'll see words like 'High' and 'Extra' coming before 'income' and 'yield', with maybe 'bond fund' or 'fixed interest trust' tacked onto the end. They take the money you invest and use it to buy and sell bonds. Typically they will hold dozens or perhaps hundreds of different bonds to minimise of the risk of an individual bond (or a few of them) defaulting.

Bond funds will invest in different regions, like the UK or Europe. They'll also usually invest in only one of the three main types of bonds, namely government bonds, corporate bonds and high yield bonds.

The key point to appreciate with bond funds is the higher the rate of income they offer, the riskier their portfolio of investments will be. A higher rate of income does not mean that one bond fund is better than another.

Most importantly, don't confuse them with ordinary bank or savings accounts. With a bond fund there will be a risk to both your capital and your income. Think hard about whether you're happy to accept these risks. If not, then you're probably better off keeping your money in the bank.

Pay no attention to past performance figures either. Because long-term interest rates have been falling in recent years, gilt and bond prices have gone up. As investors have been collecting income as well, the returns from gilts and bonds have been exceptionally good. However, there's no reason to suspect that long-term interest rates will continue to fall, meaning that bond investors will no longer get that extra kicker in their returns. Rates could rise from their current level and this would send the price of gilts and bonds down offsetting, or conceivably even exceeding, the income that they generate.

When you're comparing bond funds, make sure you know the difference between the 'running yield' and the 'redemption yield'. The running yield tells how much income you're getting on the current value of your units. The redemption yield is a much more important figure. This tells you the overall return you can expect to make when the individual bonds within the fund mature (assuming none of the companies that issued them default on their payments).

Some funds deduct their charges from the running yield while others charge them against the capital value of your fund, which can makes their running yield seem higher. This is another reason why it's better to look at the redemption yield when comparing bond funds, as it includes any annual charges. If a fund has a higher running yield than a redemption yield then it means that the value of your capital could fall if you hold the fund for a significant length of time.

Many people prefer to put their bond funds into an ISA. This is because, unlike share-based funds, you can still get a full 20% tax credit on bond funds within ISA. The tax credit for shares used to be 10% but was stopped in April 2004.

Our main gripe with bond funds is their charges. Around half of them have total annual charges of between 1% and 1.5% and many make an initial charge as well. When you're looking at a gross redemption yield in the order of 5%-6% this means a large chunk of your potential returns are going to the fund managers.

In fact, it's worth pointing out that these levels of charges are more than the 0.5% advantage that gilts have enjoyed over cash over the long term. So many investors may find it is more cost-efficient to invest directly in individual bonds rather than through a fund.

> Part I | Part II