Learn about Bonds: Building a portfolio

Building a portfolio

Building a bond portfolio for income

At the time of writing, interest rates are plumbing new lows and investors need to be creative to secure income from their money. The bond market remains a good source of assets for those seeking yield, but it is important for investors to consider that purchases of bonds should ideally be made as part of a structured portfolio plan, rather than a few random acquisitions. A well-structured portfolio holds many advantages over a single security holding, offering:

  • Assets selected to present a suitable level of potential risk & reward for the investor
  • Diversification across sectors and classes
  • Regular income flows
  • Typically, lower volatility than its individual components

Before embarking on the construction of a bond portfolio, an investor should consider what he or she wishes to achieve, and indeed, what he wishes to avoid!

  • Risk: In the current uncertain economic environment, investors who require absolute security of the return of capital should stick to Gilts and bonds issued by major sovereigns and their agencies (such as the World Bank and the European Investment Bank). More risk-positive investors may wish to lock in the higher yields available from bank, corporate and other bonds.
  • Time horizon: How long will the money be invested? If the funds are required for a specific purpose, such as children’s school fees, the maturities of the holdings can be tailored to these dates. Alternatively, retirees may wish to lock in income for the years to come and will swing their portfolio towards longer-dated issues.
  • Income: Is the portfolio for income, or will the cash flows be re-invested? Suitable selections should be made to ensure both the amount and the periodicity of the coupon payments (typically annual for corporate bonds, semi-annual for gilts).
  • Tax: bond portfolios held within ISAs or SIPPs are generally free of taxes, but investors should review their own personal situation.

The Ladder Structure

One of the most useful tricks of the trade for running a bond portfolio is the “ladder” structure, where bonds are purchased with staggered maturities ranging from short to long. Ideally, a portfolio of ten bonds should have a maturity roughly every year. This keeps the cash flow rolling back in to the portfolio and helps negate the influence of a rising rates scenario on the portfolio, enabling the redemption proceeds to be re-invested into higher coupon bonds.

Below, I have laid out two model portfolios, both using this approach.

Note; These model portfolio were constructed in February 2009. Price, yields and credit ratings shown are those in force at that time. Model portfolio constructed at a later date may utlise different bonds and yields/prices etc will vary over time).

Two Model Portfolios

(1) Gilt and AAA-rated

This portfolio is an illustration of a selection of bonds for a lower risk-investor. Due to the high credit quality of the holdings, all of which are rated AAA, a lower level of diversification can be used (three or four holdings). However the portfolio does use the “ladder” structure to keep cash moving back into the portfolio and has coupons paying in March, June, July, Sept and Dec thanks to the semi annual payment made by the two Gilt holdings. 

Bond Price Running yield Yield to redemption
Credit Rating

Gilt 3.25% Dec 2011

104.5

2.9%

1.61%

AAA

EIB 4.375% Jul 2015

106.7

4.1%

3.17%

AAA

Gilt 4.5% March 2019

108.68

4.1%

3.47%

AAA

Average 2.75%

 

Note: The running yield is based on the effective coupon received by the investor. The yield to redemption takes into account any capital gain/loss over the holding period to redemption.
 

(2) The Mixed Bond Portfolio

This portfolio aims to straddle a range of credit qualities. The risk is higher than that of the portfolio above. Greater volatility should be expected, possibly even a default. However, the average yield is higher and the portfolio also has the potential for recovery/capital appreciation. 

Bond Price Running yield Yield to redemption Credit Rating

Bank of Scotland 4.375% Dec 2009

100.5

4.4%

3.76%

AA-

Merrill Lynch  5.125% Sept 2010

99.95

5.1%

5.07%

A+

Allied Domecq 6.625% Apr 2011

101.8

6.5%

5.73%

BB+

Imperial Tobacco 6.875% 2012

104.2

6.6%

5.37%

BBB-

KFW 4.875% Jan 2013

108.05

4.5%

2.66%

AAA

Marks & Spencer 5.625% March 2014

96.2

5.4%

6.42%

BBB-

Kingfisher 5.625% Dec 2014

86.65

6.5%

8.45%

BBB-

British Telecom 8% 2016

109.45

7.3%

6.32%

BBB+

Tesco 5.5% Dec 2019

107.05

5.1%

4.57%

A-

UK Gilt 4.25% Dec 20127

100.5

4.2%

4.21%

AAA

Average
5.26%

Finally, some golden rules:

If buying corporate and non Gilt bonds, aim for a minimum of ten holdings, ideally of roughly equal size. This means that any single default will not be a disaster for the portfolio.

  • Avoid always buying the cheapest, highest yielding bond on the list; you will end up with a portfolio of junk! 

  • Try to spread purchases across both a range of sectors and a range of credit qualities and select bonds that pay coupons across the calendar.

  • When possible, to buy bonds at prices below “par” in order to preserve capital. However, good bargains can often be found in bonds trading above 100.

Readers interested in learning more about running a bond portfolio may wish to view the monthly Model Portfolio updates on this website and the regular “Bond of the week” feature, found in the Research section of the website. 

Please note, the content on this section of the website is provided for educational purposes. Examples shown of prices, yields and credit ratings may have changed since the time of publication.  

Stockcube Research,  February 2009