Fixed income investment options

Fixed income investments can provide important diversification in an investment portfolio and a high and steady income. They are typically a bit of a halfway house between shares and cash in terms of risk, though they are sensitive to where inflation and interest rates go, so they should be considered long term investments with the potential for capital loss.

What are fixed income investments?

Fixed income investments, also known as bonds, represent the debt of companies, governments or other institutions. They typically pay a fixed amount of income each year (known as a coupon) and repay the original capital at the end of a specified term. It’s an asset class that attracts investors looking to take some risk with their capital in exchange for a higher return than cash.

Income potential varies according to the issuer of the debt. More risky companies – or countries – have to pay a higher coupon to attract investors, while low risk entities can issue lower yielding debt, perhaps more in line with general inflation or interest rate expectations, reflecting the minimal risk of default (the non-payment of income or capital).

A bond’s ‘yield’ is the measure of a bond’s income and is a percentage calculated by dividing the annual income payable by the price. For instance, a bond worth 100p that pays 6p a year has a yield of 6%. You should not confuse this with interest rates payable on cash because a bond can fall in value and capital (and income) is not guaranteed.

Most fixed income investments are considered lower risk than equities but have lower potential upside and don’t usually provide an income that grows – hence the name. However, their lower volatility and ability to provide a consistent income can make them attractive as a way to balance an income portfolio, and very cautious investors may even decide to have a higher weighting to bonds than equities. Over long periods bonds and equities do not tend to move in tandem, though over shorter periods they can.

Types of fixed income investments to consider

1. Individual bonds

It is possible for investors to buy individual bonds themselves. Most promise to repay that money on a certain ‘maturity’ date, and in the meantime pay a periodic ‘coupon’ – or interest payment – to investors. However, if the issuer of any bond runs into trouble it may ‘default’ on income payments and/or repayment of capital, and thus the value of the coupon varies according to who has issued the bond. It can therefore be risky to put a lot of you money in an individual bond.

Government bonds (such as UK gilts) often pay a fairly low level of interest, reflecting their ability to be able to pay the investor back and honour income payments. These are said to have low ‘credit risk’ but they can be very sensitive to changes in inflation and interest rates, and their capital value can fall as well as rise. Bonds issued by companies (corporate bonds) pay a higher coupon, sometimes much higher in the case of more risky businesses, reflecting the creditworthiness of that firm.

Bonds usually have a finite life and are typically paid back at the same value at which they were issued, although there are some examples of ‘perpetual’ debt. During their life individual bonds can be bought and sold just like any other investment, and their value can change meaning you could get back less than you invest. Indeed, some bonds trade ‘above par’, that is above their redemption value, so for second hand buyers a capital loss could be built if held until the bond repays. However, it is worth noting that following the poor performance of the asset class over the past couple of years the reverse is often true and many bonds currently trade below their redemption price.

Prices of bonds will change from day to day according to several factors including changing interest rates, inflation expectations and the creditworthiness (or ‘rating’) of the underlying company or entity, but by investing for the period until redemption you can lock into a known return (assuming there is no default). In the event of bankruptcy, bond holders are a creditor and could receive a proportion of remaining assets, if there are any, once the company is liquidated. This is an important distinction between shares and bonds. In the event of liquidation a shareholder would likely be last in the queue to receive any money and could receive nothing at all.

2. Bond funds

Rather than buy individual bonds or gilts, investors can buy a convenient package of these investments through a ‘fund’. By investing in this way, you can spread risk while ensuring you target the asset class generally, or a particular part of it.

When you invest in a fund, such as a ‘unit trust’ or ‘open-ended investment company’ (OEIC), you are buying units alongside other investors and investing, collectively, in a portfolio of assets. Each unit has an individual price called the Net Asset Value (NAV), which is determined by the price of those assets.

Funds are either managed by a professional fund manager (in the case of ‘active’ funds) or designed to simply track a particular index (in the case of ‘passive’ funds or ‘trackers’). While it can be a challenge to devote enough time to monitor a portfolio of individual shares or bonds, it’s a lot easier to keep tabs on a few funds, so they are a popular short cut for investors to access a wide spread of investments quickly and easily.

3. Fixed income ETFs

Exchange-traded funds (ETFs), much like a unit trustor OEIC, allow you to join a collective portfolio of investments, and some invest in bonds, gilts and other fixed interest areas. But the main difference is they can be traded in real time on a stock exchange just like individual shares are, whereas other funds are traded only once a day. For this reason they may appeal to shorter-term traders as well as investors with larger sums looking to track a given index for the long term.

They are typically passive investments that come with low charges, but it’s important to note that as well as the annual charge there are costs associated with dealing in shares, notably stockbroking commission and the ‘spread’ between buying and selling prices. Therefore they may be less cost effective than funds when dealing in smaller amounts.

4. Higher yield options

Investors are naturally attracted to investments that produce a high level of income. However, a high yield can also be a warning sign. There is likely to be a very good reason why an investment yields so much such as a greater chance of default and capital loss. However, there are funds designed to produce high levels of income while aiming to control these risks through diversification.

These high yield bond funds can sometimes be useful to bring something different to a portfolio. For instance, as well as providing a higher yield than safer, investment grade bonds, they react differently to changing economic circumstances. They are more likely to be resilient in a strong economic environment where company bankruptcies are falling, whereas the threat of higher inflation and interest rates in these circumstances may have a greater effect on gilts (UK government bonds) and other bonds with lower yields.

Investment ideas

If you are looking for investments to fill a gap in your portfolio our Direct Investment Service Preferred List could help. This collection of investments is chosen by our Research Team to represent our best ideas across the major sectors.