MANY RETIRED people like to supplement their pension with some other form of income. Many simply choose to leave capital on deposit, using the interest it earns as a form of income. It depends upon what other investments you have, however, this may not be the best idea. Euro interest rates may have gone up recently but they are still very low. Sterling rates went down a couple of months ago and the financial markets are expecting further cuts in 2006. This means your income levels will be low.
Two other issues to take into consideration are tax and inflation, both of which affect the value of your capital and interest income. Interest earnings are taxed, therefore reducing your income, and inflation will eat into the spending power of your capital over time.
A useful alternative to cash on deposit are bonds. This form of investment is different from the equities (and less risky) and provides an income stream which easily rivals that of cash on deposit – the interest rates paid by bonds (depending on the type) are usually higher than the top bank rates.
Bond investment can also solve a dilemma for some people – whether to invest for income or growth. A well managed bond fund could meet both income and growth requirements.
Bonds come in all shapes and sizes and are a very useful medium for offering diversification in a portfolio. Even if you do not need income, a bond fund is still likely to be an appropriate asset to hold as part of your portfolio, especially if you are retired. In many cases, including a bond fund in your portfolio will reduce the overall level of risk.
What are bonds?
A bond is simply a loan you make to a corporation or government agency. The borrower gets the cash it needs, while you, the lender, earn interest for the term of the loan. For the use of your money, the borrower promises to pay you a specific interest rate on a regular basis for a set period of time.
Gilts
The main type of UK bond is issued by the government and these are known as gilts. As it is highly unlikely that the government would default on its debts, these are, therefore, considered the most secure UK bonds. However, they do not need to offer the higher rates of interest that other bonds offer in order to attract investors.
Corporate bonds
These are bonds issued by public companies to raise money. They pay a higher level of interest than gilts and are considered higher risk since the companies could default on the repayment of interest or capital, or both. The better the balance sheet of the company borrowing the money, the lower the risk of default – and generally the lower the rate of return on such company’s bonds.
High yield bonds
These bonds are also known as high income bonds. They are corporate bonds with a lower investment grade. This could be because the company is a new one and has not yet built up sufficient credit worthiness, or an established company which has fallen on hard times. The market has broadened over the years to include many issuers with diverse needs.
In spite of the increased level of risk, high yield bonds can be a very attractive investment option. For a start, in order to attract investors, they pay a higher level of interest than other types of bond. They also offer the potential for capital appreciation because if the company becomes successful and gets upgraded, the price of its bonds increases.
Bond funds
The level of risk with high yield bonds is lowered when you buy a bond fund. Unless you are experienced in the bond market, it is not advisable to buy and sell individual bonds. Although the principles behind bond investing are quite straightforward, it requires a great amount of expertise and experience. With a bond fund, the fund management company does the work for you. They are managed by experts, who constantly watch the markets and buy and sell bonds within the fund, in order to keep the interest and capital value as high as possible.
A bond fund will invest in a number of bonds, thereby spreading your risk since you are no longer reliant on just one or a handful of bonds. The fund manager, together with the research team, will monitor the quality of bonds and choose what they consider to be the best selection of investments for the fund. It will include companies with different credit worthiness (i.e. both corporate bonds and high yield bonds) as well as a mix of sectors, countries, currencies and so on.
Depending on the fund, you can often choose whether to receive interest payments quarterly, half yearly or annually. If you do not need the income, you can opt to reinvest the income in the fund, thus enjoying accelerated growth rates. From a tax point of view, this is very attractive as it means that you can accumulate income and gains free of both income and capital gains tax.
Expatriates living in Continental Europe may also benefit from bond funds set up specifically to meet their needs. As long as they are held within an appropriate tax efficient portfolio structure, you will benefit from a very favourable tax treatment. Depending on your circumstances you may not have to pay any tax at all!
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