Premium Bonds ‘not guaranteed return’ says expert
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The online investment platform AJ Bell explained how pension investors could be transferred to less profitable strategies without their knowledge, specifically those in the ABI Sterling Long Bond sector. They believe that “pension investors are sleepwalking into gilt investment”.
They continued: “Of course, since the pension freedoms were introduced, very few people now buy an annuity. But these lifestyling programmes, potentially set in motion 20 to 30 years ago, are still robotically moving people into gilts regardless.
“Stakeholder pensions and older workplace pensions run by insurance companies are most at risk of having a lifestyling programme in place, and it normally kicks off five years before retirement. These are dangerous algorithms, because many investors will have been defaulted into these strategies, and won’t know what they are.
“These funds have performed very well in the last ten years because of loose monetary policy, but the long-dated government bonds these funds invest in are directly in the firing line of inflation and interest rate rises. Any falls sustained in the value of these funds should be offset by rising annuity rates. But then, that’s not much use if you’re not buying an annuity.”
According to AJ Bell, there are generally three reasons why investors choose to invest through bonds: income, safety, and diversification.
“The income from government bonds has been annihilated by over a decade of loose monetary policy. Most UK gilt funds are yielding less than 1 percent, which is a poor return given the risk to capital from rising interest rates, particularly when you consider investment charges and taxes may need to be paid too.
“Corporate bonds and high yield bonds pay more, so income-seekers could consider moving up the risk spectrum into these assets, or indeed into equities, where yields are higher.”
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“UK government bonds are considered safe because they tend to exhibit low volatility, and an extremely low risk of default. If held until maturity, investors will almost certainly get their capital back, plus whatever yield they have picked up over the life of the bond.
“However, over that period the market price of the bond can fluctuate considerably, for better or worse, and that creates risk for those investors whose investment time horizon is not as long as the gilts they’re investing in.
“For instance, lifestyle fund holders will typically be invested for only one to five years, whereas the funds they are invested in will generally be holding gilts with 10-to-15-year maturities, or longer. These investors are therefore exposed to market price risk when they encash.
“For investors who aren’t going to hold gilts to maturity, but want a safe home for their money, cash looks the only sensible alternative. The interest on offer isn’t much less than that offered by government bonds and unlike gilts, the capital value won’t fall if interest rates rise. Of course, it is still subject to inflation.”
“Some investors also use bonds to diversify an equity portfolio. Right now, this is probably the most useful of the three functions that bonds can perform. While the global economy looks set to grow, if this doesn’t prove to be the case, some bonds in a portfolio can help.
“This is particularly the case for those with shorter investment horizons. An investor with 20 or 30 years to go before retirement on the other hand, can be more sanguine about equity market falls, as they can simply wait for them to recover. There is little need for bonds, even though most pension default funds will contain them, no matter what your age.
“There is a school of thought which says that gilts are best for diversification, because they have a lower correlation with shares. There is definitely some merit to this approach, but the present imbalance between risk and reward in the government bond markets suggests investors pursuing this strategy might wish to temper their gilt exposure by holding more short-dated funds.
“Alternatively, they may choose to switch some of their gilt holdings to Strategic Bond funds and accept they may have a more highly correlated portfolio, but have dodged some of the valuation risk in the gilt market.”
AJ Bell also gave advice on the potential risk/reward nature of corporate bonds, and the benefits they may bring as an investment strategy compared to gilts.
They said: “Unlike gilts, corporate bonds carry a higher interest rate, which cushions the impact of price falls emanating from fears of tighter monetary policy. They also tend to be shorter dated, which means they are less sensitive to interest rate rises.
“In a rising interest rate scenario, these ‘riskier’ bond funds should fare better than ‘safer’ gilt funds. Of course, if the economy takes a dive, it’s gilts which fare better than corporate bonds.”
However, Laith Khalaf, head of investment analysis at AJ Bell has advised retirement investors to steer clear of bonds at the moment, due to historically low interest rates which he says are limiting their effectiveness.
He said: “Bond might be taking the cinema scene by storm, but it’s no time to buy bonds on the capital markets. Energy price rises are giving markets the jitters, inflation is on the rise and central banks are talking about tightening monetary policy, all of which has led to a sell-off in UK gilts.
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