Pick bonds to spruce up an ISA
22nd March 2013 17:12
by Nick Louth from interactive investor
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There's nothing in the name of a stocks and shares ISA to suggest it would be a good place to hold individual bonds, but in fact there is no better way to get the full power of tax-free income returns than to acquire a mix of safe but solid fixed-income holdings.
Although British government bonds are not great value at the moment, there is still a good choice of corporate bonds, preference shares and other fixed-income issues out there that are not only safer than shares in the same entities, they usually pay higher income. Best of all, the London Stock Exchanges (LSE) retail bond platform, the Order Book for Retail Bonds, has made it easier for small private investors to choose from both new and existing issues.
"Bonds and ISAs are a great mix," says Mark Glowrey, head of retail bonds at Canaccord Genuity. "Most people think of equities for ISAs, with a view to capital gain. Yet most of us don't actually use the full tax-free capital gains allowance [£11,200 in 2012-13], but we all pay income tax. When you bear in mind that bonds, unlike shares, pay their income gross, you can see the advantage that an ISA represents."
Rock-bottom interest rates since 2008 have fanned the hunt for yield. Havens such as gilts, and AAA-rated corporate debt have gradually become much more expensive, and now price rises have spread all the way to obscure high-yielding areas, with subordinated debt and permanent interest-bearing shares in building societies among them.
It's harder now to find big incomes in the very safest companies, but not impossible. While a one-year bond in Unilever, for example, would earn just 1.5% - and be too short-run to qualify for inclusion in an ISA - those prepared to buy a long-term or perpetual bond can easily earn 5% in similarly safe firms, and even more from subordinated issues.
While bond funds are an instant way to diversify risk, they come at a cost. When the main source of return on a bond is its income, to find that a fund takes up to 1% in charges can mean a significant slice of your income, perhaps as much as a third, is being trousered by someone else.
"You should buy a selection of bonds," says Glowrey. "While it may not be easy to build a bond portfolio in one year, gradually adding holdings can be an easy way to do this."
Choosing bonds is harder than choosing shares because there is so little retail analyst coverage. That doesn't have to make life hard. While reading a bond prospectus is likely to tax anyone's concentration, there are quite a few sources of free material online. A selection of useful resources is given at the end of this article.
However, buying bonds still isn't always straightforward. Many online brokerages, though allowing investors to hold bonds in their ISAs, don't have many on their automated systems, so searches for stock codes often come up empty. This often means dealing over the phone. The bid-offer spread for liquid issues isn't too demanding, but for those buying obscure preference shares or subordinated bonds, the spread can sometimes be as wide as 10 points. Some stockbrokers that are members of Euroclear, and do not have to deal via the LSE, are able to get narrower spreads. There is also an embryonic bulletin board, FIOB - Fixed Income Order Book - that is worth a look.
The table above shows six bonds. They are all household names, largely in the financial sector, any of which would provide some good stability in an ISA. The gross redemption yield (the total return if a bond is held to repayment) is the crucial figure here. All offer returns of 4% or more, which is something that few bonds outside the financial sector offer. Maturities range from five years (Provident Financial) to a perpetual from insurer RSA, that is perhaps a tad riskier than the others. It is a subordinated issue and has the possibility of a call in December 2014, which would cut the coupon by just over a couple of points, depending on prevailing Treasury five-year gilt yield.
Useful sources of information:
www.londonstockexchange.com/prices-and-markets/retail-bonds/faqs/faqsalias.htm