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Chapter 2: Why buy bonds? The risks and rewards of investing in bonds

The last four decades have seen the emergence, growth and eventually the almost total domination of equity investing. Prior to this, pension funds had invested mainly in bonds, the view being that fixed income securities were a logical and safe home for the money. All this was to change in the 1950s, in a move largely credited to the then fund manager of Imperial Tobacco, George Ross Goobey. Mr Goobey, an actuary by profession, reached the conclusion that equities were undervalued and started switching the fund into the then unfashionable stock market.

He was right. Over the coming decades, inflation destroyed the real return from fixed income securities and equities proved the place to be. This view, sometimes known as the “cult of the equity” is now almost a universal belief with equities widely considered to be the first choice for investment.

But is this the whole story?

When an investment approach is almost universally adopted, it’s often time to worry. Certainly, the bear market in the early 2000s eroded the longer-term outperformance of stocks against bonds; undermining the theory that bonds are simply an antiquated asset class, suitable for only the most unadventurous or complacent investors.

At the time of publication of this book, the argument for equities looks somewhat weaker than usual. The highly respected 2011 Barclays Equity-Gilt study (now in its 56^th year of publication) shows that UK Government bonds have outperformed equities over a ten year period and are virtually level-pegging over a twenty-year period.

The figures shown below are “annual real returns” (i.e. inflation adjusted). Income is assumed to be re-invested.

Table 2.1: comparative performance of UK equities and gilts

What is more, the performance that bonds have provided over the last couple of decades has been delivered with far fewer heart-stopping moments than the thrills and spills experienced by equity holders over the 1987 crash, the millennium technology boom and bust, the flash crash of 2010 etc. (I could go on!)

Consider also that a balanced portfolio with a mixture of equity and bond holdings will show lower volatility than a pure equity portfolio.

Of course, past performance does not dictate future performance but these statistics somewhat undermine the theory that bonds are simply an antiquated asset class, suitable for only the most unadventurous or complacent investors.

The rewards

Before we move on to consider the potential risks and rewards of different types of bonds, here are seven good reasons why every portfolio should contain bonds:

1. Security

Government bonds have historically offered the investor unparalleled security. Even in the current credit crisis, the risk of the UK or other major governments being unable to repay their debts is comparatively low. Of course, we live in a changing world, and the Greek financial crisis and growing indebtedness of the Western world means that investors should not be complacent. An asset class that has been historically safe may not be safe in the future. Nevertheless, higher-quality government bonds should theoretically be considered superior in credit quality to a bank deposit. Why? Basically because governments have the power to levy taxation in order to service their debt.

High-grade, multi-national government agencies (such as the World Bank) also offer an extremely safe home for the investor holding bonds to maturity. Of course, not all bonds are issued by governments or their agencies. Many bonds are issued by companies and other organisations whose ability to service the debt may be less certain. However, even corporate debt can be considered a safer investment than the company’s equity. In the event of bankruptcy, bondholders are ranked above shareholders in their claim on the company’s assets.

2. Return of capital

Bonds also differ from equities in one other very important aspect. In order to realise your profit (or loss) on a share, you are wholly dependent on the ability to sell the instrument back to the market. When an investor buys a bond, the redemption date is fixed in advance, reducing the investor’s reliance on the uncertainties of future market sentiment or liquidity.

3. Income

With an ageing population in most developed countries, income becomes an increasingly valuable aspect for any portfolio. Income available from bonds is generally higher than that available from equities. Also, future income payments are a known quantity, unlike dividends from equities, which may be reduced or withheld entirely in times of low profitability. This makes bonds ideal for investors who wish to secure future income over a defined period of time. With bonds paying annually, semi-annually or sometimes quarterly, a carefully chosen bond portfolio with six or more holdings can produce a reliable monthly income.

Also, most bonds pay their coupons gross, without withholding tax. Investors can take advantage of this by holding qualifying bonds within an ISA, producing a tax free income for life, hopefully rolling up the full £10,000 allowance year after year to build up a meaningful sum.

4. Capital growth

Bonds are associated with income, and understandably so. But, a stream of income, if received gross and re-invested can be a powerful tool for capital growth. With the advent of low-cost and easily available tax-efficient ISA and SIPP accounts, this is now a workable strategy for the UK investor.

Tip

Seven is the magic number. A 7% income, if re-invested, will double a sum of money over a decade.

5. Diversification

A well managed portfolio should contain a variety of different assets classes; equities, government bonds, index-linked bonds, corporate bonds, property and alternative assets all have their role to play. This simple approach, also known as “not keeping all your eggs in one basket” is one of the most effective strategies for reducing risk in a portfolio. In certain economic scenarios, such as a recession, bonds will generally show an inverse correlation in price movements to equities. Note that in the 2000-2003 period, when the FTSE100 declined by nearly half from the millennium highs, longer-dated gilts saw prices rise over the same period (as can be seen in the following chart).

Figure 2.1: long-dated gilts v. FTSE 100 (2000-2003)

6. Benefit from falling interest rates

When an investor buys a fixed coupon bond, he or she locks in interest rates for a defined period. Because of this, falling interest rates will cause the market value of the bond to rise. Investors who buy bonds in falling interest rate scenarios will receive the double benefit of a secure income and capital appreciation of their asset.

7. Speculation

Many financial instruments offer the potential to speculate on future price movements, and bonds are no exception. Liquid government bonds are often used by traders speculating on future interest rates while corporate bonds can see sharp price movements from changes in the perceived credit quality of the issuer.

To summarise, bonds as an asset class are about income investing. This is not to say that such a strategy can not produce capital growth – the power of a re-invested stream of coupons is a powerful tool.

Historically, UK investment has been about chasing capital gains. This is perhaps due to the history and the memory of post-war inflation and the relatively (I stress relatively) lenient tax treatment of capital gains. Income gained on investments has historically gone straight on to the investor’s top rate of marginal tax.

The development and now wide acceptance of ISA and SIPP account allow bonds, and indeed other income-producing assets to be held within a simple, legal inexpensive tax shelter. This has been a game changer for the approach of many investors, and I would venture the opinion that this development has further to run over the next few decades.

The risks

All investments involve risk, and bonds are no exception. Indeed, as some savers with the Icelandic banks and their subsidiaries discovered in 2008, not even bank deposits are truly risk free. Before we go on to consider the relative risk of the fixed income and equity asset classes, it is worth taking a moment to consider the different types of risk that an investor might face. Investment risk can be broken down into roughly five categories as follows:

1. Risk of default

The risk that the issuer may be unable to return all or some of the money advanced to them. In the bond markets this is known as a default and in the unlikely event that the issuer defaults or goes bankrupt, you may lose some, or all, of your investment.

2. Market risk

The investor buys a bond at a price. This price will then fluctuate from day to day according to interest rate expectations and credit rating changes, creating a paper profit or loss. Thus, if the investor needs to sell the asset to raise funds, they face a risk of capital loss.

3. Issue-specific risk

Many bonds are issued with imbedded features such as calls, which enable the issuer to repay the debt ahead of schedule. This can be disadvantageous to the holder. However, such features are clearly laid out in the bond prospectus, so careful investors can either avoid such issues, or make contingency plans.

4. Event and operational risks

Operational risk encompasses a variety of hazards such as brokerage charges, slippage or a shift to an unfavourable or punitive tax treatment. These types of risk can be reduced through careful planning and monitoring. An example of event risk would be the issuer of the bond becoming the target of a leveraged buyout, increasing the degree of risk of lending money to the company.

5. Inflation

We can also add to this list the risk of inflation, which can reduce the real value of any asset or portfolio over time. Bonds, with their fixed interest and redemption payments are particularly vulnerable to this risk.