We believe bonds have an important role to play in a diversified portfolio. In the long term, having a portfolio that invests in a combination of stocks, bonds and other assets smooths returns throughout the market cycle.
In addition to offering diversification, bonds generally pay a fixed interest rate and can therefore be useful in generating income. Most bonds are considered “lower risk” than investing in the stocks of a company.
The easiest way for individual investors to gain exposure to bonds is to use a fund. Like equity funds, they come in all forms, investing in different areas of the fixed income market to generate returns – providing exposure to different parts of the market or to regions of the world.
There are two main types of bonds – those issued by governments and those issued by businesses, called corporate bonds.
When companies issue debt, they can choose whether or not to pay a rating agency to “assess” their debt. A credit score helps investors determine the degree of risk of the investment by providing an independent and objective assessment of the credit worthiness of a business and, ultimately, its likelihood of being able to make the promised payments.
A high credit rating indicates a high probability that the borrower will be able to meet its financial commitments in the future, which will include paying the interest and paying off the loan at the end of its term.
A low credit rating means that the company is more likely to default and be unable to meet its obligations. It is important to note, however, that the credit rating expressed is an opinion of the rating agency and should not be considered as a guarantee of future events.
Unrated bonds
Some companies choose not to get a credit rating when issuing debt. This may be due to a number of reasons – they may find that the program is too small to justify a rating, or that the cost of obtaining a rating is too high. When issued without rating, a bond is called unrated. Without a rating, however, it is more difficult for investors to assess the credit quality of the business and, ultimately, the risk of default.
Due to the lack of ratings, there are fewer analysts covering these types of bonds, and ultimately a smaller number of investors. This means that it can be more difficult to buy and sell unrated bonds, creating what is known as liquidity risk.
High Yield Bonds
Companies that are less financially secure and therefore have a higher risk of defaulting on their debt often have to offer higher returns to investors to compensate them for the additional risk taken by lending them money. Therefore, this type of bond has the potential to operate differently from other sectors of the bond market.
This sector of the market has performed well recently. In 2019, high-yield, high-risk bonds generated the best returns of the year in all major bond sectors of the Investment Association (IA) with annual yields of 11.5% *, although it is not a guide for the future. During a downturn, they are unlikely to provide shelter and we expect them to be more volatile. * Source: Lipper IM at 12/31/2019.
Addition of risks for potential returns
Eric Holt, manager of the Royal London Sterling Extra Yield Bond fund invests in market sectors that most other investors overlook, including unrated and higher-yielding bonds, which increases risk. He believes that these areas offer opportunities to exploit the inefficiencies of the credit market. The liquidity of unrated bonds is often lower and issuers have tended to pay a premium on the yields of rated bonds to help compensate investors for the additional uncertainty associated with their holding. Holt and his team are experienced in investing in more unknown areas and hold a wide range of bonds so that fund returns are not based on a single holding, however due to the higher liquidity and risk of default associated with unrated and high yield bonds, we would consider the fund as an adventurous option.
As it is an offshore fund, investors are normally not entitled to compensation through the UK Financial Services Compensation Scheme.
Learn more about this fund, including the fees.
Key investor information