Sterling bonds - opportunities

Q I have been used to investing into sterling bond funds from recognised banks as they have offered reasonable returns of around 5% per annum over the last three years. With sterling interest rates hovering around 4.5%, I now think that these funds do not offer real value as I am only receiving around 0.5% more than the bank base rate. What are the opportunities for increasing my returns from sterling bond funds that offer a wider investment choice, such as unrated bonds?

A One of the first concepts of investing is that of risk and return. If a bond fund is yielding 5% and consists entirely of UK government bonds, then you must accept that as being a reasonable return, compared with the 'no-risk' rate of return of 4.5%.

If on the other hand you wish a return of 8%, then clearly that bond fund must contain a high level of corporate bonds that are also likely to contain much lower-rated bonds than gilts. The higher the potential return, the higher the potential risk.

You have also asked about unrated bonds. You can do this most securely through funds that hold over 100 different bonds, which are typically rated BB/BBB, but that also include unrated bonds.

While most investors are aware of the ratings attached to bonds, such as BBB, there is a widely held misconception that unrated bonds are more risky than rated bonds. Such misconceptions can therefore be taken advantage of by prudent investors.

An unrated bond means that a credit agency has not attached a rating to it, e.g. BBB or AA. The absence of such a rating does not necessarily make the unrated bond more risky than a rated one. In fact, unlike rated bonds, most unrated securities have secured characteristics, allowing the bondholder first legal charge on specified assets in the event of a default.

Despite the fact these bonds offer better protection to the investor, they also usually offer enhanced yields in compensation for the lack of a rating.

A credit rating tells the investor the probability of a security defaulting, i.e. the future likelihood that the company will not be able to meet its obligation on a bond that it has issued. The highest rating is AAA, which implies the default risk is at its lowest.

Although credit ratings are important, they do not provide the investor with all the information needed to know whether a bond is fairly priced. Even though they attempt to assess the probability of a security defaulting, they do not reveal the security's likely recovery rate, or take into account what changes could happen to the company in the future.

Approximately 10% of UK FTSE100 companies have unrated bonds in issuance. One of the reasons why issuers may choose not to rate their bonds is because bond ratings cost a lot of money.

In the case of a small bond issue, many borrowers find it less expensive to pay a higher rate of interest to the investor than to incur the cost of a bond rating. Many of these unrated bonds have investment grade qualities and the right selection can prove fruitful.

By only buying bonds with a credit rating, an investor runs the risk of missing out on the unrated sector of the bond market, which offers higher than average yields.

There are now UCITS registered funds that include unrated bonds within their funds, which enhance the overall yield of the fund. Over the past 12 months, returns in the region of 11% in sterling have been typical.

As UCITS, Maltese investors can take advantage of the 15% withholding tax option when receiving the income distributions as opposed to 35% tax on non-UCITS and non-locally registered funds.

Mark Hollingsworth is the director of Hollingsworth International Financial Services - licensed by the MFSA to provide investment services under the Investment Services Act 1994 (IS/32457). Address any financial questions to: Mark Hollingsworth, c/o The Sunday Times, PO Box 328, Valletta CMR 01. Alternatively, he can be contacted on 2131-6298/9984-2614 (office hours) or e-mail mh@hollingsworth-int.com.

Past performance is no guide to the future and, except where amounts are guaranteed, the price of your investments (and the currency in which it is denominated) may fall as well as rise. Your personal tax situation will depend on residence. Always consult a professional adviser. This article does not intend to give investment advice and its contents should not be construed as such. Readers are encouraged to seek professional advice on their personal financial situation.