Could Bonds Be Your Answer To Low Bank Interest Rates?

25.08.09

Please note that this article is over six months old. While Blevins Franks takes care to make sure that information is accurate on the date of publication, some content may change over time. You should not rely on the accuracy of legislation and tax information in this article; take professional advice for your circumstances.

With more positive news emerging on economic recovery, savers will be hoping that interest rates should soon rise off their historic lows. Unfortunately expectations are growing in the City that

With more positive news emerging on economic recovery, savers will be hoping that interest rates should soon rise off their historic lows. Unfortunately expectations are growing in the City that UK interest rates could remain low for the foreseeable future ? possibly for as long as four years. If you need your savings to provide an income or capital growth, and now that the economic news is more encouraging, it may be time to move them into assets with higher return prospects.

In August the Bank of England surprised the market by extending its quantitative easing programme by ?50 billion to ?175 billion, breaking the ?150 billion ceiling set by the Chancellor. Markets were even more surprised when the minutes of the Monetary Policy Committee meeting revealed that the Governor, Mervyn King, had wanted a higher increase of ?75 billion. He was outvoted, but this was a strong sign that the Bank may pump even more money into the financial system, making it unlikely to consider raising its base interest rate.

According to Gerard Lyons, the chief economist at Standard Chartered Bank, the Bank of England may not increase rates at all during King?s term as Governor, which lasts until mid-2013. ?The Bank should be congratulated on their practical response to this crisis. There is no way that the Bank of England is going to prematurely tighten policy,? he said.

Other economists also point out that the UK?s huge fiscal deficit means that once next year?s general election is out of the way the government, whatever colour it is, will have to raise taxes and cut spending. Interest rates would then need to be kept low to keep the economy moving.

If you have had enough of the paltry interest you are earning from your bank deposits, and are starting to think it is time to invest your cash, you are not alone. In the UK, record sums poured into funds from cash over the second quarter. This was into both equity and bond funds, though corporate bonds were the most popular sector.

In mid August corporate bond issuance leapt through the $1,000 billion barrier for the year ? this was the first time this has happened and there are still four months to go. Volumes in Sterling, Euros and US Dollars all rose to record highs.

Companies are having difficulties obtaining bank loans and so are issuing more bonds to raise money and there is strong demand from investors looking for higher yields than cash or government bonds.

Investing in bonds through proven bond funds are particularly useful investments for those looking for:

1) Income from their capital, usually attractively higher than that offered by bank accounts.

2) Capital growth over the longer term, but with less risk than equities.

3) An asset allocation tool to help balance portfolio risk.

You would normally buy bonds through a fund, something even more important in these tricky financial times. Fund managers are closer to the market and skilled in buying and selling bonds. The funds hold a number (it could easily be over 100) of different bonds, helping diffuse risk. They would also hold bonds from a range of credit ratings to help increase the income potential at the same time as reducing risk.

The ability for some companies to meet the income payments and maturity values of their bonds has obviously been a factor for this sector as a result of the financial crisis. As a result companies have to offer higher interest than usual to attract investors. This makes it a good time to buy corporate bonds ? the interest is fixed – especially since capital values fell last year. While prices are picking up, many bonds are still very good value.

As with all investments, some bonds are good and others are not. In respect of corporate bond funds, the key is to select a proven investment manager who is able to manage their fund so as to generate the best returns without taking unnecessary risk. What this means is not buying corporate bonds purely because of their yield, but also to understand the financial strength of each company so that they pick the bonds that offer the best value and to have confidence in the companies? abilities to return both income and capital.

There have recently been some reports warning that the strong corporate bond rally has begun to show signs of over extension. As with equities, you can get both bullish and bearish commentary at the same time, but neither of them can accurately predict the future. In any case, if you are invested for the longer term these short term predictions are less of a concern.

The reports are also mainly talking about the investment grade bonds, which are more vulnerable to changes in government bond yields inspired by either supply or inflation perceptions and to a lesser extent to default risk.

High yield bonds, on the other hand, act more like equities and tend to perform well during times of economic growth ? and we are now in recovery mode. While there will be corrections from time to time there is still great value in a considerable number of corporate bonds. Selection is the key ? which is where experienced fund managers play their part ? and with the numerous high yielding opportunities available and the fact there is still a large volume of cash waiting to be invested, high yield bonds remain an attractive investment for medium to long-term investors. Much of the risk has reduced; the market is returning to a healthier state and offers reasonable returns even once the peak has passed.

It is important to remember that the value of the bonds can fall as well as rise, unlike a bank account. Your investment choices should be based on your circumstances and objectives. Speak to an experienced financial adviser like Blevins Franks to determine the best options for you.

By Bill Blevins, Managing Director, Blevins Franks

21st August 2009

Tax rates, scope and reliefs may change. Any statements concerning taxation are based upon our understanding of current taxation laws and practices which are subject to change. Tax information has been summarised; individuals should seek personalised advice.

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