Bond ratings

I have invested in individual emerging market bonds such as Brazil and Venezuela due to the high coupons they pay. More recently I have invested also into High Income Funds as they spread the risk over many different bond issues. I now favour the lower risk fund route but am looking for further opportunities into funds that invest in unrated/smaller bond issues. Are there any EU listed funds that one can invest in?

Firstly, I am glad that you have diversified your portfolio to include funds. You are absolutely correct that this approach vastly reduces your risk compared to individual holdings.

An interesting statistic highlights that one should have between 110-160 bonds in a portfolio to achieve the same diversification that a portfolio of 50 individual stocks would give (source: Royal London).

There is therefore a misconception that holding individual bonds is low- risk. This cannot be further from the truth (unless of course all your holdings are AAA government bonds).

In the case of a portfolio of ten individual equities, if one plummets, there is still a large potential upside from the other nine to 'cancel out' the loss of the other one.

In the case of bonds, there is not the same potential upside as equities since they trade in much shorter ranges. If you therefore hold ten individual bonds and one defaults, then the other nine are highly unlikely to make up for the loss of the one that fails.

You therefore need to hold a considerable amount of individual bonds to achieve equal diversification as stocks. The idea behind investing in a fund is therefore to create that diversification for you.

If you wish to invest in emerging market bonds, for example, then you would have to invest into a considerable number, and at a considerable cost, to achieve the same diversification that one single bond fund would achieve.

Regarding your other point on unrated bonds, there are a limited number of funds that include such bonds. Firstly however, I wish to clarify a general misunderstanding on what an unrated bond actually is.

Being unrated does not mean they are automatically high-risk. It simply means that the company issuing the bond has elected not to go to the large expense of hiring a credit agency to rate it.

Also, unlike rated bonds, most unrated securities have secured characteristics, allowing the bondholder first legal charge on specified assets in the event of a default.

Despite the fact these bonds offer better protection to the investor, they also usually offer enhanced yields in compensation for the lack of a rating.

You can invest into funds that are a mixture of investment grade and unrated bonds that are registered for sale to retail investors in the EU, i.e. UCITS.

Any distributions to, or capital gains realised by, a Maltese resident also qualify for a 15% final withholding tax when the investor opts to have those distributions or capital gains paid to him/her. This is so long as they use the services of an authorised financial intermediary in Malta.

Mark Hollingsworth is the director of Hollingsworth International Financial Services - licensed by the MFSA to provide investment services under the Investment Services Act 1994 (IS/32457). Address any financial questions to: Mark Hollingsworth, c/o The Sunday Times, PO Box 328, Valletta CMR 01. Alternatively, he can be contacted on 2131-6298/9984-2614 (office hours) or e-mail mh@hollingsworth-int.com.

Past performance is no guide to the future and, except where amounts are guaranteed, the price of your investments (and the currency in which it is denominated) may fall as well as rise. Your personal tax situation will depend on residence. Always consult a professional adviser. This article does not intend to give investment advice and its contents should not be construed as such. Readers are encouraged to seek professional advice on their personal financial situation.