This article is part of Morningstar’s Guide to Your Financial Education, providing our readers with the tools they need to become a successful private investor.
Emma Wall: Hello, and welcome to Morningstar. I'm Emma Wall and here with me today is John Pattullo, co-manager of the Henderson Strategic Bond Fund.
Hello, John.
John Pattullo: Hi.
Wall: As part of our Financial Education Week, we're taking things back to basics for those who are coming to fixed income for the first time and those who need a bit of a refresher. So, wanted to ask you what exactly is a bond?
Pattullo: Yes, good question, because equities get a lot of press and bonds don't get much press at all. I mean, a bond is an IOU. It's a financial obligation. You lend money and there is an obligation to pay back that money. They're generally tradable. They tend to have a fixed maturity date and they have a fixed coupon or payment of interest which has to get paid, otherwise it's a default. So, countries issue bonds and companies issue bonds as well, and they pay different coupons subject to the risk.
Wall: I think people are aware of quite how diversified equities are as a sector. They tend to lump fixed income in together, whereas actually they're quite disparate and there are as many different bonds as there are issuers, in fact more?
Pattullo: That's really a good point. I mean fixed income is a generic phrase. I mean Tesco (TSCO), for example, have over 50 bonds but only one equity. Bonds in different countries, currencies, coupons, maturities all sorts of things. There is lots of intakes of fixed income, I mean, typically sovereign bonds to countries. There is investment grade companies, so reasonably good quality companies. There is high-yield companies or junk bonds, as it is known; there is asset-backed bonds; there is securitised bonds; there is a whole host and the markets are actually huge. So there is lots of risks and returns available for clients subject to the objectives that they're trying to meet.
Wall: In a beginner's guide it’s good to use the rating system, but I think this can be quite confusing. We hear AAA this and BB that. Who issues these ratings and what exactly do they mean?
Pattullo: Yeah. There are two big rating agencies in the world, there is Moody's and Standard & Poor's. So, the issuer of the bonds typically pays them money to get a rating. Better-rated bonds trade at lower yields than worst-rated bonds. So there is an advantage of getting a rating. And as you say, the ratings spectrum varies right out from AAA all the way down to CCC and if not actually down to D for default.
Half the universe is broadly investment grade and half is high-yield and it very much depends on – there is no saying that just because it's AAA, oh, it's a very good quality, but that means that you don't get much yield. And just in the same way a junk bond or a high yield bond is not necessarily a bad thing. It's just a different risk/return profile and my job is really to get the best risk-adjusted returns as you can imagine for the clients.
Wall: A very simplified measure would be though; the greater the yield, greater the risk?
Pattullo: That's exactly right. And you got to build into that a degree of how long away the maturity is, the volatility of the bonds, and the whole host of different factors such as the cyclicality of earnings of the company you are talking about, the quality of the management team, the jurisdiction that's in, all those sorts of things would get blended up into the yield of the bond. That's the rule of thumb which always works.
Wall: I suppose it's your job then to balance chasing that income which everybody wants at the moment and going after something that's too risky to invest in.
Pattullo: Exactly. We are in a long credit cycle which is getting reasonably mature and I think buying this month's issuance may not be the best return for our clients. If anything, we prefer some of the older, more reliable names, who have been around for a while, bonds trade quite well, proven management teams, all that sort of stuff, rather than the late cycle types of bonds, in our opinion, where I don't think the risk-adjusted returns are necessarily that appealing.
Wall: John, thank you very much.
Pattullo: Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
