Bonds have a reputation for being complicated. They aren’t. Underneath the terminology, a bond is simply an IOU – literally, “I owe you” : you lend money, and in return you’re promised a fixed income each year, with your original sum returned at the end of the term. That’s it.
We wanted to set out, plainly, why bonds sit in your portfolio at all, and why the bonds we choose for you are deliberately the least exciting ones available.
The other side of the loan
Usually, a government or a large company. When you hold a bond, you can also sell it on to someone else if you want your money back sooner, which is why the industry calls you a bondholder rather than simply a lender. It’s a small distinction, but it explains a word you’ll see used a lot.
Source: Albion Strategic Consulting
Making sense of risk and reward
Here’s the idea: the riskier the borrower, the more they have to pay you to make it worth your while lending to them.
That’s not a promise that risk pays off, it’s compensation for the chance that it won’t. A borrower who’s very likely to repay you doesn’t need to offer much, because you’re taking on very little uncertainty. A borrower who’s struggling has to offer a lot more, purely to persuade anyone to lend to them at all, because there’s a real possibility they won’t pay you back in full, or on time.
Lend to a government like the UK, the US, or Germany, and you’ll be paid modestly, because repayment is close to guaranteed. Lend to a company that’s in financial difficulty, and you’ll be offered a much higher rate, but you’re also taking on a real chance of losing some or all of your money.
So it’s less “take more risk, get more reward,” and more “you’re paid more for risk precisely because it might not come off“. Whether that trade-off is worth it is exactly the kind of decision we make on your behalf, based on what your portfolio actually needs.
Assessing a borrower’s creditworthiness is a specialist task in its own right, which is exactly why we don’t rely on guesswork. We draw on independent rating agencies, whose sole job is analysing borrowers’ finances in depth, and combine that with our own view before any bond fund earns a place in your portfolio.
Source: Albion Strategic Consulting
Why we lean toward the steadier choice
Fair question. If some bonds pay more, why not hold more of those?
In practice, company shares tend to do a better job of growing your wealth over the long run, so that’s where we look when we want growth. The higher-paying bonds, often called high yield bonds, have a habit of losing value alongside the stock market when things get difficult, without reliably making up for it in the good years. In 2008, for example, they fell in step with shares rather than holding steady
Source: Albion Strategic Consulting
The steadier bonds, known as investment grade, are lent to reliable governments and strong companies. They didn’t try to keep pace with shares, but when 2008 hit, they held their ground and gave investors somewhere safe to be. That steadiness is exactly why they earn their place in your plan.
We call this part of your portfolio your defensive assets, the calm, dependable layer that means the rest of your money can afford to take a bit more risk in pursuit of growth.
If you take one thing from this
At its core, a bond is just an IOU between you and a borrower, a government or a company, and that IOU can be passed on to someone else, along with the right to receive the payments
What actually matters is how long the loan runs, and how much you can trust the borrower to pay you back, and that trust isn’t guesswork, it’s assessed by independent rating agencies
Reliable borrowers and shorter lending periods both mean greater certainty of getting your money back, which is exactly why we favour shorter-term bonds from strong borrowers within your portfolio
None of this needs to be worked out alone. And if this has left you with questions, about bonds or anything else to do with your plan, we’d love to hear them. That’s exactly what we’re here for.
Risk warnings
This article is general information only, not personal advice, and nothing in it should be taken as a recommendation to buy, sell, or arrange any investment. It reflects our thinking at the time of writing, which may change. Past performance is never a guarantee of what’s to come.
Where we’ve referred to specific products or examples, it’s to illustrate a point, not to endorse or recommend them, and it shouldn’t be taken as analysis or due diligence on our part.
Every situation is different, so any decisions about your own investments should always be made solely in consultation with a qualified and regulated financial adviser.
Wells Gibson Limited is authorised and regulated by the Financial Conduct Authority (Firm Reference Number 731027).
