This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, in a piece for Morningstar's Guide Financial Education, Shaun Port, Nutmeg’s CIO explains why they have taken a cautious stance on bonds.
Fixed income securities, commonly known as bonds, are generally regarded as safer investments than company stocks. Bonds come in many flavours, such as safe bonds, like those issued by the UK government, and much riskier bonds, like those issued by companies with a poor credit record, known as ‘junk’ or ‘high-yield’ bonds, or by countries with a less than perfect record of making repayments – Argentina is a current example.
The values of bonds are largely based on two factors: the time to maturity – that is, the time until the face value of the bond is paid back – and the likelihood, however small, that the borrower will default on payments. Because bonds normally pay a fixed rate of interest on the face value, one of the biggest threats to holding a bond for a long period is the rate of inflation – in other words, how much today’s pound will be worth in the future: even at just 2% inflation, £100 today will only be worth £82 in 10 years.
Bonds and bond markets are quoted as a yield rather than prices. The yield is a theoretical compound rate you would earn if every interest payment was re-invested back in the bond at current prices. Bond prices work in reverse with yield. Falling yields mean prices are rising whereas rising yields mean lower prices.
Caution in the Bond Market
For the past 18 months we have been cautious on bonds. Across the wide range of bond markets, yields are close to all-time lows. Indeed, in continental Europe bond yields are the lowest in some 500 years. Put differently, prices are sky-high. In higher risk markets like High Yield the yield is around half that when the financial crisis was past its worst in February 2009. Moreover, in the safer bond markets – which do well in times of crisis – yields are actually lower now.
Yields are low for a reason. Bond yields are anchored by the official interest rate, which is near zero in most developed countries. And as investors search for higher returns, they take on more risk – for instance buying company bonds with a higher risk of default. There are also many forced buyers of government bonds, such as banks and pension schemes, which push prices up and yields down.
Central Banks have been very big buyers of government bonds since the crisis. The US is winding down its bond buying programme, while the UK stopped some time ago. In fact, the Bank of England owns 40% of all conventional gilts in issue. This has artificially kept yields low, by design.
Over the next few years we expect government bond yields to rise much further. Economic growth is picking up – not as strong as in the pre-crisis days, but not enough to justify near 0% interest rates. And inflation appears to have reached a trough in many developed markets, albeit not in several European countries.
We have generally preferred to hold UK corporate bonds rather than government bonds, for better returns and less sensitivity to rising interest rates. In riskier bond investments, we sold all holdings in emerging market bonds in June 2013 and more recently in April 2014 we sold all high yielding junk bonds. Simply, these offered less potential reward for the level of risk.
To limit the damage from rising government bond yields, we invest in corporate bonds with a shorter time to maturity. The prices of bonds closer to maturity are less sensitive to changes in yields. This is designed to limit potential losses from a generalised rise in interest rates and yields. Indeed, over May to December 2013 the yield on the government bond market rose from 1.6% to 2.4%, which resulted in a loss of 5.6. Despite this, corporate bonds with a short date to maturity of less than five years gained 0.1%.
Even though bonds are a useful lower risk investment, in an environment of rising interest rates we believe it is sensible to be prudent when investing in bonds – even if this means missing some return when government bonds have the occasional good run.
