“You don’t need bonds, until you need them!”Anonymous
Today, investors face some challenging choices when it comes to investing in bonds, not least because yields on bonds are at historical lows and currently below that of UK inflation. In response to the very low yield on bonds, some investors have been tempted to chase higher yielding bonds, in an attempt to squeeze some return out of what feels like an unproductive portfolio allocation. This is, unfortunately, an accident waiting to happen. The phrase ‘picking up pennies in front of a steamroller’ comes to mind.
Other investors, including clients of Wells Gibson are asking whether they should instead be holding cash. This has been a theme, on-and-off, for almost a decade since the era of low yields began, driven by quantitative easing by the Bank of England in response to the Credit Crisis. Those taking the cash deposit route over this period have paid a heavy price, losing 15% of purchasing power compared to just 3% from being invested in short-term government bonds.
The challenge is to make decisions today that will help to protect, preserve and create wealth over time and, most importantly, allow investors to remain invested in the markets at the worst of times.
Why own bonds at all?
As investors, it’s our emotional and financial ability to suffer falls in the value of our shares, which tends to determine how much risk we can take on. Very few investors have the stomach for a 100% global equity portfolio.
Investors who cannot emotionally, or financially, afford to suffer falls in the value of their portfolio have to reduce their allocation to equities / shares and own more stable and therefore lower returning bonds to offset these falls.
We should be looking forward to yield rises
At some point in the future, yields are likely to rise to higher levels. The problem is that no-one knows when, how quickly and with what magnitude it will happen. Investors should be looking forward to yield rises, because in the future their bonds will be delivering them with a higher yield, hopefully above the rate of inflation.
When yields do rise, bond prices will fall, creating temporarylosses. At that point bonds earn an investor more than they did before the rate rise and they reach a breakeven point when the new higher yield has fully compensated them for the temporary capital losses suffered. The time to break even is equivalent to the duration (similar to maturity) of an investor’s bond holdings. Short-dated bonds with a three-year duration will breakeven after three years.
Bonds are a very important part of most portfolios, providing lower absolute levels of volatility than equities and protecting portfolios from periods of severe equity market trauma that occur from time to time. Be prepared for unexciting returns as yields – potentially – move back to a more normal level. No one knows when or how quickly this will happen, so don’t try to second guess the guessers. Sit back and remember: ‘You don’t need bonds until you need them!