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How to create your own DIY corporate bond portfolio

Posted By The Investor On In Investing | 11 Comments

Investing in Corporate Bonds [1]

The Order Book for Retail Bonds (ORB) has proved a useful addition to the UK investing landscape. With shares about as attractive to most people as rabies and the average cash savings [14] account paying no more than a bag of marbles, the London Stock Exchange’s ORB [15] has made corporate bonds [1] the answer to at least some income-seekers’ prayers.

Such is the demand for retail bonds – that is, corporate bonds from big companies like Lloyds [16], Tesco, and Severn Trent aimed at everyday private investors, and listed on the ORB – that there’s even been an opportunity to stag new issues [13] for a small profit.

But what if you want to buy a portfolio of directly held corporate bonds, perhaps as an alternative to investing in a corporate bond fund or ETF?

Is that feasible?

Let’s leave aside for today the question of whether or not corporate bonds should have a place in our portfolios. Some say yes, some say no. Most of the passive investing experts we like on Monevator skip corporate bonds altogether in their model ETF portfolios [17].

Personally, I’m not mad keen on owning large helpings of corporate bonds, and I’d certainly stress they’re no direct swap for government bonds [18]. Corporate bonds will behave very differently in a deep recession to UK government bonds, for a start. They’re also far more likely to default.

I can well understand the counter-argument [19] that gilt yields are severely and artificially depressed, though, and that investing some portion of your bond money in corporate bonds is a rational response – especially if it’s only a small portion, perhaps offset by holding more cash [20].

How to create your own corporate bond portfolio

In this (ridiculously enormous) post I’ll focus on the following aspects of constructing a DIY corporate bond portfolio:

I’ll then suggest a practical way forward if you’re keen.

Note that while directly holding corporate bonds is quite popular in Europe, it’s still something of a novelty in the UK – a bit like olive oil was in the 1980s or kissing both cheeks in the 1990s.

I’ve never personally constructed my own corporate bond portfolio, nor have most other British private investors. It wasn’t even very feasible before the ORB arrived.

So please treat this as an introductory article for further discussion and your own research, not as a rulebook carved in stone.

Accessibility of suitable bonds

Over 100 corporate bonds are now listed on the ORB [21], and new issues are arriving all the time.

Online brokers are well placed to see the appetite for these retail bonds – brokers like Selftrade [22] and Halifax Sharedealing [23]regularly highlight new issues on their home pages.

Retail bonds are also being written about more frequently in the financial news pages [24], as well as on specialist bond sites.

These retail bonds are very private investor friendly. Specific bonds are tradable in lots of as little as £1,000 (as opposed to £50,000 or more for some issues in the main bond market) and they can be held in stocks and shares ISAs, where the income will be entirely shielded from income tax.

Note the five-year rule when buying retail bonds in an ISA: You can only purchase bonds in your ISA if they have five years or more years left to run when you buy them. However after buying them you can hold them and collect the income they pay until they mature, when they’re redeemed at their face value for cash.

You can put twice as much money into a stocks and shares ISA as you can a cash ISA1 [25]. This means you could invest your entire annual ISA allocation in corporate bonds if you wanted, which would give you a tax-free yield on up to the £11,280 ISA allowance [26] in 2012/2013  (plus any amounts you’ve put into ISAs in previous years, of course).

Outside of an ISA, bonds are taxed as income. Depending on your tax status, it might be best to hold your dividend-paying shares outside of an ISA – if you have to choose – and to shield your corporate bonds inside an ISA, since the effective tax rate is lower on dividend income [27] from shares then on bond income.

Ease of evaluating retail bonds

At first glance, bonds look like straightforward investments – especially new issues, and especially compared to equities.

To buy a bond, you can simply invest in a new issue sporting a known interest rate, and then sit back and enjoy the regular income it pays until it matures and gives you your cash back. Then you can rinse and repeat.

Because you know exactly how much money you’ll get when you buy a bond2 [28] there’s much less uncertainty than there is with shares, where both the future share price and also the dividend income stream are unknown.

However a few things make bonds trickier than they initially appear.

Firstly, corporate bonds can default [12], either on their interest payments, or by not repaying you in full when they mature (or both!) This is the big uncertainty with corporate bonds, especially compared to UK government bonds (gilts).3 [29]

Secondly, while it’s easy to see the income you’ll be due on a bond when it’s first issued (and not hard to find the yield-to-maturity of bonds [10] trading in the secondary market) it’s not so easy to work out whether this will prove a good return or not, once future inflation, interest rates, and other macro-economic factors are taken into account. This matters because corporate bonds are relatively low return investments, and most have no inflation-protection [30].

Finally, shifting perceptions about the safety of a corporate bond and the real return it will offer – as well as overall changes in the demand for bonds – means that once it has started trading on the market, the price of a bond [4] can wobble all over the place.

If you sell a bond before it matures when its price happens to be lower than you paid for it – or if you buy a bond that’s trading above its face value and hold until it matures – then you will get less back than you invested.4 [31]

Some commentators – including the legendary Ivy League portfolio manager David Swenson – argue that these factors together make bonds harder to analyse than equities.

In my opinion the difficulties are less pronounced if you’re investing in the relatively limited pool of new issues in the ORB, though, and also if you intend to hold to maturity.

Only fairly solid companies have come to the ORB to raise money so far, and most have only around six or seven years to run to maturity, which reduces the risk somewhat. If you buy when they first list and hold until maturity, then you can ignore the price fluctuations in-between, too.

Still, you will need to know – and have a view about – the company that issued any bond you’re investing in, and you must invest knowing you could lose [32] some or all your money.

The Fixed Income Investor website is the best resource I know of for helping you evaluate retail bonds. I recommend you check it out if you decide to create your own DIY bond portfolio.

Prospects for diversification

Trying to diversify properly [33] is the biggest snag for private investors creating their own corporate bond portfolio.

The elephant in the room is the risk of default.

While I think it’s unlikely that the retail bonds that have been listed on the ORB so far will not pay their coupons and repay your capital when they mature, it’s definitely not guaranteed they will.

And unlike with a High Street savings account, you won’t be compensated by the FSA should a retail bond not pay you what you’re due in full.

This makes corporate bonds far more risky than cash. It also means that constructing your own portfolio of corporate bonds is too probably too risky for many smaller investors, since they won’t be able to sufficiently diversify away the risk of a blow-up.

If you owned just five corporate bonds, say, and one went to zero, then you could lose 20% of your initial investment. In practice you’d probably get at least some money back after bankruptcy proceedings, but it could be a long wait and there’s no telling how much you’d get. There’s nothing to say only one bond will default, either, especially in a deep depression when many companies could fail.

The historical data on corporate bonds is clear: they can and do default, with the probability of default increasing sharply as their credit rating reduces. Default is not just a far-flung theoretical possibility!

So how many different corporate bonds would you need to hold to achieve sufficient diversity? Nobody knows!

The iShares corporate bond ETF (Ticker: SLXX) holds 50 different bonds, so that’s one reference point.

On the other hand I’ve seen estimates suggesting as few as ten [34] or 20 bonds will be sufficient.

To further complicate matters, having plenty of bonds from different companies – and eventually a ladder of different maturities – isn’t the end of the story when it comes to diversification.

A lot of the bonds that have been listed on the ORB so far are from the financial, retail, or utility sectors. Diversifying into 20 different companies would remove much of the risk of an individual company failure, but it wouldn’t go far in reducing the risk of macro-economic factors like a slowing economy killing off multiple retailers.

Personally I’d be biased towards more diversification [35], not less, if I were putting a serious amount of my money into corporate bonds. I’d certainly try to spread my bond investment [36] between different industry sectors, rather than just going for the highest yielding – or even the highest grade – bonds.

This probably points to getting any initial exposure to corporate bonds from a corporate bond ETF (or an investment trust or fund that buys bonds, if that’s your wont) and adding a few individual retail bonds as the icing on your cake, and maybe shifting your weighting to directly held bonds over time. More below.

Running costs of a corporate bond portfolio

This is where a DIY bond portfolio really shines. If you invest in retail bonds when they’re issued and hold them until they mature, there are no dealing fees or annual running costs to pay.5 [37]

In contrast, even the iShares corporate bond ETF has a Total Expense Ratio [38] of 0.2% a year. More to the point, the actively managed bond funds that investors have poured money into in recent years can charge around 1% or more a year – which is a hefty slice of the 4 to 5% or so in income being paid by investment grade corporate bonds. Buy and hold individual bonds yourself, and you avoid paying these annual expenses to fund managers.

As I say, the cheapest way is to invest in new issues. If you do decide to actively trade your retail bond portfolio, or to buy after they’ve already listed on the ORB, then there will be dealing fees to pay (though no stamp duty, in contrast to shares).

You’ll need to familiarize yourself with calculating bond yields [11] if you trade listed bonds. I’d suggest keeping turnover to a minimum to reduce costs, too.

A practical way forward

Overall I think the idea of construction a DIY bond portfolio has legs, due to the relatively minimum amounts (‘pieces’ in bond speak) that you need to invest to invest in each ORB-listed bond, and the cheapness of doing so – particularly if investing in new issues.

By putting money into a few new issues every year or by buying them in the secondary market, you can develop a ladder of corporate bonds, picking up the income every year until they mature in a few years time, and then rolling the money into new issues.

The big difficulty is getting sufficient diversification in your DIY corporate bond portfolio.

It will take a long time for you to get to even 20 different holdings if you only invest in new issues a year, let alone the 50 or more held by a bond fund.

You can buy already-trading bonds, but there will be a cost for doing so, and you’ll also have to watch out for premiums and spreads.

One solution could be to put most of your corporate bond money into an ETF or bond fund for the diversification, and to invest a relatively small percentage in retail bonds for their potentially higher income, lower running costs, or simply because you fancy owning some bonds.

You could proceed to build up a directly owned retail bond portfolio over time, by swapping bond ETF money into new issues, or by adding new cash. But by putting the bulk of your initial corporate bond allocation into a fund, you’d be diversified from day one.

Finally, remember that bonds are like shares in that their fortunes will shift with the prospects for the companies that issue them. This means you’ll need to keep up with events at the companies, and perhaps even look to sell bonds that you think could ultimately default – preferably before their price falls too much!

But here we get into the usual pitfalls of active investing.

If you’re looking for an easy life, if you’ve better things to do than read the financial pages – or if you’ve just decided you’ve no special skills to bring to the table so you’re happy to passive track the bond market – then you’re probably best passive investing [39] through a bond ETF.

For keen active investors, though, the Order Book for Retail Bonds [13] puts constructing your own DIY bond portfolio within reach.

Series NavigationDoes opportunity knock in the UK retail bond market? [13]
  1. You can put from zero to half of your total annual ISA allowance into a cash ISA, and make up the rest with a stocks and shares ISA. [↩ [44]]
  2. By investing in a new bond you will hope to get the annual interest you are due each year, plus your capital back on maturity. [↩ [45]]
  3. Shares can go bust too, of course, and you are at far greater risk of capital loss or dilution holding shares in a company than if you own its bonds. But in exchange for this extra risk you would expect to eventually earn higher returns from shares than you would expect to get from bonds. [↩ [46]]
  4. Note that this can still be worth doing if the income makes it worthwhile. [↩ [47]]
  5. Except the annual fees charged by your broker or platform, of course, which you’d probably also pay if you instead held ETFs or funds on that platform. [↩ [48]]