By Dante Peters
With the Bank of England finally raising interest rates to 0.75% in August, only the second rise in a decade, it felt like a good time to talk about bonds.
With bond yields at low levels since the financial crisis of 2008, investors may have considered moving their money into cash deposits instead, in pursuit of better returns. But those taking the cash deposit route will have paid a heavy price in the past 10 years, losing 15% of their purchasing power in that time, compared to just 3% experienced by those investing in short-term government bonds (hedged to GBP).1
‘Investment grade’ bonds should be a key component of any balanced, risk-aware portfolio. If you'd humour a snooker analogy for a moment, bonds are the Steve Davis of asset classes. They are monotonous, mundane and occasionally, mildly boring. But they represent a good insurance policy when placed in a portfolio alongside higher-risk asset classes such as equities - very much the Jimmy White in our snooker metaphor. We’ve all enjoyed watching a Jimmy White clearance in the past, but few of us would back him to bring about long-term sustainable success.
The key is getting the balance right between the Davis’s and the White’s in your portfolio.
Different investors have different approaches to their bond/equity split. When bond returns are low and equity markets are going up, you may wish you owned more equities, or that your bonds were working harder for you. But predicting or pre-empting the market is not an easy game to play, and is not one I would recommend.
To underline the point, below is a table showing how different equity/bond allocations fared during the Credit Crisis. Spoiler alert, the 'boring bonds' saved the day:
Figure 1: Adding bonds helps reduce downside falls – Credit Crisis (Nov-2007 to Feb-2009)
Data: Nominal returns. MSCI UK Index (net), Citi WGBI 1-5 Years (hedged to GBP). No costs of any kind deducted. Rebalanced annually. Source: Morningstar Direct © Copyright. All rights reserved
Bonds: the basics
A bond is debt issued by a company or government looking to raise capital. Investors ‘buy’ the debt, or bond, which basically means they lend money to the bond ‘issuer’. In return, the investor receives a fixed rate of interest, or a ‘coupon’, from the issuer. The bond has a ‘maturity date’, at which point the issuer will repay the principle amount to the investor.
Not all bonds can be considered ‘Steve Davis-safe’. Some, like short-dated UK government bonds, are indeed low-risk. But others are more equity-like in their nature, and are higher-risk as a result.
Who’s behind the bonds?
This is a key question for any sensible investor. You wouldn’t back a three-legged horse in the Grand National, and lending your money to a high-risk company is equally ill-advised. Of course, like the horse, a high-risk company may surprise you. But it’s highly, highly unlikely.
Fortunately, most bonds are assigned a credit rating by rating agencies like S&P and Moody’s, which gives investors an idea of an issuer’s reliability before investing. Bonds rated AAA-BBB are considered ‘investment grade’, while BBB and below are deemed ‘high-yield’, or ‘sub-investment grade’ - formally known as ‘junk bonds’.
The maturity date also impacts the yield of the bond. Put simply, the longer to maturity, the more volatile the bond’s yield. Put together, these two factors can make a difference to an investor’s returns. Bonds with lower credit ratings have poor defensive qualities - if that same bond has a long maturity, the bond may perform even worse.
And that brings us back to the Steve Davis bond; the short-term, investment grade bond, providing a sensible balance between yield and protection. They will get the job done for your portfolio when equity markets are in turmoil, while still giving you a more reliable return than inflation-ravaged cash deposits.
1 Data: Cash = UK 1 month T-bill adjusted by UK RPI; bonds = Citi WGBI 1-5 Year Hedged GBP from 02/1988 To 02/2018 adjusted by UK RPI. Source: Dimensional Returns 3.0.
Past performance is not necessarily a guide to future performance and you may get back less than invested.
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