This communication is for informational purposes only and is not intended to constitute, and should not be construed as, investment advice, investment recommendations or investment research. You should seek advice from a professional adviser before embarking on any financial planning activity. Whilst every effort has been made to ensure the information contained in this communication is correct, it is subject to change and we are not responsible for any errors or omissions.
As an individual nears retirement, it is common to start thinking about “de-risking” their pension(s). In simple terms, this involves moving investments away from volatile ones – e.g. shares which can fluctuate rapidly in price – towards less volatile ones.
Bonds are commonly held up as an ideal asset class to move assets into (to achieve de-risking). Yet what are bonds exactly? In particular, how do “bond funds” work and where should they sit within a pension?
Below, our financial advisers in Murcia discuss how bonds can be relevant to British expats looking to achieve their retirement goals. We hope these insights are helpful. If you want to discuss your financial plan with a member of our team in Murcia, please get in touch to arrange a no-obligation financial consultation, at our expense:
+34 966 460 407
info@scottsdale.eu
What are bonds?
To understand bond funds, it helps to first have a basic grasp of bonds. A bond is a type of “I.O.U” between you (the investor) and a borrower, such as a company or national government.
Similar to a bank loan, investors can lend money to the latter with the intention of eventually getting their money back (at the bond’s “maturity date” – e.g. in 2 years) – with interest (a coupon) earned along the way.
For instance, suppose you buy a £100 bond with a 2% coupon and a 5-year duration. Each year, you get a £2 coupon. By year 5, provided the borrower has not defaulted, you should get your £100 back with a total profit of £10.
You can hold a bond until its maturity date, or you can try selling it to other investors before then. If so, you may or may not make a profit on the sale depending on what others are prepared to pay. This will largely be dictated by wider economic conditions.
Interest rates, in particular, play a key role. If rates have fallen and are expected to keep falling in the near future, then your bond may offer a better rate than newly issued bonds. Therefore, investors may be prepared to pay more for it. However, the opposite will likely be true if interest rates are forecast to rise.
What are bond funds?
Rather than buying a bond directly from a company or government, another option is to put money into a “bond fund”. Here, the fund manager pools investors’ money into many different bonds. The returns are then distributed to investors (e.g. as dividends) and/or reinvested back into the fund, buying more bonds.
Since a bond fund trades on a stock exchange (similar to a company stock), its share price can fluctuate. As a general rule, the less volatile a fund’s share price, the lower its “yield” will be. Conversely, a more volatile bond fund will tend to offer a higher yield to compensate investors for the higher risk.
An example of a “lower risk” bond fund might be a fund which invests solely in short-term UK government bonds (known as “gilts”). Here, investors can have high confidence in the quick repayment of their money.
By contrast, a “higher risk” bond might invest primarily in bonds issued by governments in the developing world. Here, there might be a greater chance of default. Therefore, investors are offered higher yields to compensate.
Should I hold bonds in my pension?
The “nightmare” scenario that a British expat wants to avoid is a crash in the value of their pension(s) right before retirement. For instance, in March 2020 the average UK pension fund fell by 11.6% as COVID-19 took its toll on the markets.
Bonds can be a useful tool for diversifying an investor’s portfolio as they near retirement. Rather than relying completely (or mainly) on shares, bonds can act as a “counterweight” to negative stock market performance – helping to shield the overall value of a portfolio.
Historically, bonds have had an inverse relationship to stocks. When the latter falls, the former rises – and vice versa. Moreover, bonds provide a regular income to investors – e.g. from dividends if using a bond fund, or from interest payments if holding bonds directly. This can also be attractive to those nearing retirement since the goal tends to move away from “capital growth” towards “decumulation” (when assets are geared towards providing an income).
However, it is important to seek financial advice before making significant changes to your investment strategy. The precise “balance” of shares to bonds, for instance, will vary depending on your unique financial goals, situation, investment horizon and attitude to volatility and risk. Moreover, the wider “macro” environment will be important to consider. Diversification is also important, helping to spread your risk across multiple assets and asset classes.
Invitation
If you are interested in discussing your own financial plan or inheritance tax strategy with us, please get in touch to arrange a no-commitment financial consultation at our expense:
+34 966 460 407
info@scottsdale.eu