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Bonds are considered a defensive play. But that doesnt mean investors shouldnt have an active game plan.

Everyone needs to have aprocess in place and, when it comes to bonds, its no different. Most importantly, due diligence should be applied to the hybrids now flooding the market.

Four-point plan

A handy four-point plan would include:

■ First, having a strategy that identifies which bonds you want to buy and why.

■ Second, just like sharemarket investing, have a plan in place if you need to sell. In an ideal world, investing for income implies holding the asset to maturity but these days, as people chase any sort of yield, they need to stand ready to change their portfolio.

■ Third, employ a process for determining when to increase or decrease portfolio exposure to the overall market.

Bonds deliver solid returns when interest rates drop, as their prices move in the opposite direction to interest rates. But when rates start to rise, bonds will decline in value. However, the loss will be crystallised only if bonds are sold before maturity. That might be fine if youre investing in government bonds, but corporate issues and hybrids require a more active approach. If there is any sign that the global outlook is improving, then bonds will underperform.

Hybrid guidelines

When it comes to hybrids, which are the flavour of the month right now, the first thing to remember is that they will not grow in value like shares. Getting your money back plus the promised coupon payments is as good as it gets. But if you do go chasing yield, remember these few guidelines:

■ A big interest payment wont necessarily compensate you for any potential large capital loss.

There may be two or more possible maturity dates and although its highly likely the repayment will be at the earliest date, a borrower that runs into a problem can choose not to repay at the first call date. The investor is then at risk for as long as 20 years.

■ Also, is the issue repaid as cash or converted into shares? At times, distributions can be put off under the terms in the prospectus. If deferred, they may be compounded and paid later or just missed altogether. Missing out on any payment defeats the idea of holding assets for income in the first place.

■ Liquidity will be poor: if you need to sell, will there be buyers available at what you consider to be a fair price? A larger issue is likely to be more liquid, but the problem could still apply.

Fleeting popularity?

Hybrid issues can be less volatile than shares but more so than bonds. Hybrids are popular right now but the higher yield does imply there are more risks. In the past, they have done very well but it might not be the most opportune time to buy into this asset class.

The main driver of returns in a bond fund is the running yield, and thats the reason to hold bonds.

If you have a corporate bond representing 3 per cent of the portfolio and you lose that capital, you have wiped out much of the years return.

For those holding bonds as a defensive asset, this is a worry.

Another is asking whether small investors are fully aware of the risks in hybrid issues, which have become so popular with the yield conscious.

Safety buffer

Bond holders need to ensure theres some extra margin in their fixed-interest portfolios risk structure.

It is also important to remember that the risks of major capital losses increase sharply when the terms move from, say, one year to five or 10 years. And, of course, the risks are greater when current yields are relatively low and there is a climate of potential increases in yields.

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