And she’s buying a stairway to heaven...

Fixed income, as an asset class, has a dour reputation. It’s not sexy. You know the price you are paying, you know the coupon you will receive, and you know the redemption value; barring a catastrophe from the issuing company, the financials are all mapped out. In normal market conditions, you are unlikely to see a 50% rise in capital value at all, let alone in a short period of time. They are as predictable an investment as you are able to get, providing you buy and hold to maturity.

But predictable is good. Predictable is what we, as income investors, seek and it should be what you seek as well. Our equity income focus is on reliability and sustainability of income; fixed income assets, in the form of Gilts (Government debt) and individual corporate bonds fits in with that. If excitement is a capital value that is down 35% one year and up 50% the next, or a high dividend which may or may not be sustainable, then that isn’t for us. Shouldn’t every portfolio be based upon assets whose return is already known?

For most investors, exposure to this sector will be via a collective investment (unit trust, OEIC or ETF); there is nothing intrinsically wrong with this approach and for the majority of investors it is the only realistic way to access the asset class. Managers such as Richard Woolnough (M&G), Paul Causer and Paul Read (Invesco) and Stephen Snowden (Kames) have built strong reputations with their bond funds, and have many loyal investors.

However, investors with larger portfolios would do well to consider investing via individual bonds, using a technique known as the bond ladder, and for us, this is where fixed income investing gets interesting.

The simplest form of a bond portfolio would be a collection of fixed maturity issues, i.e. if you require the return of capital in five years’ time you buy a collection of five year bonds. However, since the changes to pensions mean that investors no longer have to annuitise, investment attitudes have changed; more investors find that they no longer have a target date for their capital, but have ongoing income requirements.

For investors with this longevity of investment (and it’s not just those with pensions) then a bond ladder, a rolling maturity portfolio, with no defined exit date, may well be appropriate.

The theory is simple: you decide the length of the ladder – in our example it is ten years – then purchase a range of corporate bonds or Gilts with increasing maturities from one year to ten years. The intention then is each year that a bond matures, the proceeds are rolled over into a new ten year bond.

The benefits of the bond ladder are:

  • You are not locked-in to one bond with a distant maturity (only one tenth is locked-in)
  • There is immunisation against moves in interest rates as you are buying new bonds, at the prevalent rates, each year
  • You are assured of liquidity back into your portfolio each year through coupons and maturities
  • You can manufacture a monthly income by selecting bonds with different coupon dates

There are downsides; there is reduced liquidity as the majority of your capital is tied up for at least twelve months, and if you need all your capital back you might not be able to get as much on the secondary market as you paid. There is also the default risk, which exists with any single issuer (for equities and corporate bonds), and you could lose both the coupon and the capital.

Despite the risks, we like bond ladders, and seeing one in action is a thing of beauty. Sadly, however, the current corporate bond market is so corrupted by the effects of quantitative easing that we find it hard to recommend a single individual bond for investment, let alone sufficient to create a ladder. Watch this space though…quantitative easing is on the way out, and sooner or later interest rates will move up, the fixed income market will suffer a shake-out and will become a place where sensible investment can once again be made. When that happens bond ladders will return to being the bedrock of long term investment planning.

doug brodie