How to diversify your portfolio with fixed term bonds

Posted by Grace MatthewsJul 08, 2019

Diversification is key to investment success and a good portfolio is a balanced portfolio.
There’s nothing technical or obscure about this. It merely means achieving a spread of investments, not betting the ranch on one asset class, not putting all your nest eggs in one basket.

The reasons underlying this principle are straightforward. If you were to put all your money into one industry, or sector, or geographical region, you’re giving a hostage to fortune. If they do badly for any reason, then so will the value of your whole portfolio.

But, if you’ve put together a carefully chosen and balanced range of investments, then, not only will your exposure to one type of asset be limited, but often, falls in the value of one, will be compensated by rises in another, as other investors shun the poorly performing and drive up demand for alternatives.

Traditionally the diversified investment fund approach has been to go for a combination of bonds and equities to maximise the potential for a smooth return over the medium to long-term. Bonds are a form of IOU, a fixed income certificate that represents a loan issued by a government, company or other institution. They usually pay a set rate of return over a fixed number of years.

This traditional balanced fund is often used for pensions, where the split is typically 60:40 between the two major asset classes of bonds and equities.

But, it’s also important to achieve a balance between different types of equity and between different kinds of bonds. Both can be based on property or real estate, which has long been one of the most popular assets.

 

Growing popularity in property bonds

According to the Wealth and Assets survey by the Office for National Statistics (ONS), about half (49%) of non-retired UK adults chose property as the best investment, making it consistently the most popular investment option since 2010. The proportion of people who still put property as the top investment has grown by 9% from 40% back in 2010-2012.

So, property remains the second most important asset class after cash and, as such, it will always have an important role to play in any well balanced investment portfolio.

However, that still begs the question: is how best to get into property?

A glib answer, of course, is to buy land and build a house. But that calls for a lot of capital and specialist skills. Likewise, buying a property, improving it and selling it for a profit isn’t easy either, again needing capital and skills, as well as a shrewd eye for a bargain and a thorough knowledge of the local market.

Until recently buy-to-let was a popular route into property investment. But the government put the brakes on this runaway sector with a stamp duty hike, restricted tax relief on interest payments and tighter mortgage regulation. Quoted in the FT, Ed Mead, founder of property services company Viewber, says: “All the benefits to owning a buy-to-let property are being taken away.’’

The investor still has the option of diversifying their investment portfolio by investing in shares in a publicly listed builder or by investing in a property fund.

Most of the UK’s largest property companies – such as British Land and Land Securities - have converted to REITs, property investment companies whose shares can be bought and sold on the stock exchange. 

Shares, however, carry greater potential risk than some other forms of investment. In 2016 several property funds were forced to halt withdrawals following the EU referendum as investors rushed to take money out. Property funds run by Standard Life, Columbia Threadneedle, Janus Henderson, M&G, Aviva and more suspended withdrawals.

An alternative to shares are bonds. As we’ve discussed, they’re a form of IOU where the investor lends their money to the issuer, which commits to repay the amount loaned – the face value of the bond –after a set number of years. The bonds also pay interest, at regular, set intervals, at a rate which is fixed.

A bond will generally not offer as high a rate of return as stocks and shares, but it does have other advantages.

First, the fact that it pays a stated income at fixed times gives a portfolio a valuable element of certainty. The investor can plan knowing there is high chance of these returns. A diversified portfolio containing a number of bonds, paying at different intervals can provide a fairly constant income stream and, if the bonds have different maturity dates, the investor can have a rolling series of redemptions which helps liquidity. Investors must always ensure they don’t tie all their capital so that there’s none available for an emergency.

Second, bonds typically offer a lower rate of return than equities because they carry less risk. Their face value doesn’t fluctuate depending on the fortunes of the company issuing them or depending on the overall state of the markets. This is why they’re so valuable in balancing the more volatile equities in a diversified portfolio.

They also provide an easy way for the saver to invest in the property market through property bonds, issued by a company to fund property projects, including the purchase of land or properties.

Property bonds usually bring a further element of security in that they can be secured against the asset whose acquisition or development they were issued to fund.

However, as with any investment, there’s still an element of risk. The downside is that returns are not guaranteed, should there be a market downturn this could have a negative impact on investments. However that is not to say that all investments would be lost.

Tax benefits of fixed term bonds

Finally, it’s now possible to invest in property bonds and take advantage of some valuable tax benefits. 

You can pay up to £20,000 a year into an Individual Savings Account or ISA, without incurring any tax liability on the income or on capital gains. In 2016, the government introduced the Innovative Finance ISA, as a way of extending the ISA tax advantages to the growing peer-to-peer lending market. The IFISA allows individuals to use some, or all, of their annual ISA investment allowance to lend funds through the peer to peer lending market and buy other debt based securities and this includes property bonds.

A property bond in an IFISA, which can be held in addition to other ISAs, is a useful, tax efficient way, of achieving portfolio diversification in terms of: balance of risks and rewards; a mix of equity and bonds; fixed income as against variable income; and participation in the property market.