Questor: one of our bonds is about to mature. Where can we get a good return on the proceeds?

Bonds are supposed to be less trouble than shares – barring disaster, you know what return you will get from them if held to maturity – and so it has proved with our Income Portfolio. In the five years or more of the portfolio’s existence, only one of our bond holdings (Premier Oil) has worried us enough to prompt a sale; the others have just carried on quietly producing the income their issuers are contractually required to pay.

Now however we need to make another change – not because of any unwelcome development with a bond holding but simply because one of them, the Paragon 6.125pc issue, is about to mature. Investors will get their money back on or shortly after Jan 30.

Or, to be strictly accurate, some, Questor included, will get most of their money back. We did not invest when the bond was issued, which was in 2014, but instead bought on the open market in January 2017, when the bonds were trading at more than “par” value. So from the outset, we were guaranteed a capital loss if we held to maturity.

It may sound odd to buy an investment certain to lose capital value but, of course, that is to look at only half the story: that loss is more than made up for by the income. We paid £104.60 for the bonds and will receive par value of £100, so our capital loss is 4.4pc; our income, meanwhile, is £6.12½ a year per bond, or £5.85½ per £100 invested – 5.9pc more or less.

We will have owned the bonds for five years so our aggregate return from the interest is 29.3pc; against that figure the 4.4pc capital loss is bearable. It is big enough, however, to take our annualised total return to a shade less than 5pc – the target we set ourselves when the portfolio was established. Now that inflation has taken off, a fixed annual return of 5pc of the amount invested is not really enough – its real value will quickly be eroded.

We must bear this in mind now when we choose an investment to replace these bonds. This vulnerability to inflation is found in all fixed-income investments of course but we don’t want to give up on them entirely – they provide valuable balance to the portfolio and that very certainty of income comes into its own when other sources falter. 

This is something we saw starkly in 2020 when the virus’s arrival caused several of our individual company holdings to cancel their dividends; our bonds continued to pay their interest without interruption.

But if we want the benefits of fixed, secure interest and at the same time avoid losing much of the return to inflation, currently at 5.4pc, we need to find bonds that pay comfortably more than that rate. This is no easy task. Paragon’s own bonds that mature in two and a half years’ time, for example, offer a total annual return of just 2.3pc because their 6pc coupon is heavily undermined by a market price almost 10pc above par value.

Clearly this other Paragon bond is no good as a replacement for the one that’s about to mature. Where then can we put the money we are about to receive where it will contribute fully to meeting our income target?

What we are seeking is a bond investment that will pay a yield of comfortably more than 5pc without too much risk. That is a very tall order in today’s environment and the only answer this column can see is to pick a couple of specialist funds that can offer that crucial risk-reward combination because they operate in specific niches of the market where great experience and expertise on the part of their managers enable borrowers to be found who are both prepared to pay high interest rates and unlikely to default.

Both of the funds we have in mind – BioPharma Credit, which yields 7.1pc, and Real Estate Credit Investments, whose yield is 7.7pc – are already part of this portfolio, although rather fortunately we have smaller positions in them than in most other holdings. 

We can therefore top them up, on a 50:50 basis, with the proceeds of the Paragon bond’s maturity without creating excessive exposure. This is what we will do as soon as the Paragon bond matures.

Questor says: buy BioPharma Credit, Real Estate Credit Investments

Ticker: BPCR, RECI

Share price at close: 99 cents, 155p

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