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Bonds still have a place in your ISA or SIPP

Some bonds are now trading with negative yields, which means that they lose money as an investment. For example, a one-year bond that pays no coupons (interest payments) and returns £100 to the investor when the year is up, might cost £101.

Bonds change hand as stocks do, and investors have accepted prices that make some bond yields negative. But why would they pay more now for less later? If investors are worried about a stock market crash they may park their money in government bonds because they view them as safer than stocks.  This drives bond prices up and forces yields down.

A pension fund may be obligated to have a percentage of its holdings in high-quality bonds no matter the yield, or perhaps it has an obligation to meet in the future and has to invest in a negative yield bond to meet it. A bond trader may think bond prices will continue to rise, and they can sell the bond before it matures for a profit.

Yielding confusion

Something else to consider is that there are different measures of yield and different types of bonds. Up until now, we have considered only zero-coupon bonds that pay back their face value at the end of the term, with nothing in between.

A coupon paying bond can have a negative yield to maturity (YTM) but a positive current yield, which is just the coupon payment divided by the price paid. YTM is a more comprehensive calculation that assumes the bond is held until it matures and incorporates the timing and amount of coupons and face value received.

Bonds can be issued by companies as well as governments, with terms of months or many years, with coupons at fixed amounts or that float according to an underlying reference rate. Bond investing can be confusing compared to buying stocks, but buying good quality bond funds means you do not have to worry about what bonds to buy and when.

Think of it this way – investors are pushing yields lower because they really want the benefits of bonds in their portfolios. You should consider them also.

Don’t break the bond

The prices of good quality bonds typically don’t move in the same direction as the stock market, which means a portfolio’s value with bonds included should not swing as widely as it would without them. This is what diversification is all about.

Investors that make regular withdrawals of cash from their portfolio can benefit from a regular stream of coupon payments and some bonds also provide inflation protection, which is good for the long-term investor.

I would avoid funds that invest in emerging markets and high-yield corporate bonds, because in times of stress these behave more like equities, and look for funds that invest in bonds issued by the governments of developed countries and global investment-grade debt. These will diversify a portfolio of stocks and shares.

As an example, the Allianz Strategic Bond Fund does this, is highly rated, and tries to protect the sterling value of your investment. Of course, you will also want to make sure you stock and share investments are of good quality.

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James J. McCombie has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.