How bonds could boost your portfolio
By
Deputy Editor
Tim Bennett Aug 22, 2008
Print this article
"Either it's financial Armageddon, or it's just too cheap." That's how John Pattullo, director of fixed income at Henderson, recently described the corporate bonds market to the Financial Times. Current prices for the best quality "investment grade" bonds suggest that the market expects a 15-17% default rate. Yet as Pattullo notes, "the worst ever five-year cumulative period since 1970 saw a 2.3% default rate". On top of this, according to the Barclays 2008 Equity Gilt study, corporate bonds have generated a real annual return of 4.2% over the past ten years. That beats UK government bonds ("gilts"), at 3.3%, equities at 3.1% and cash, at just 2.5%. So now could be what Hargreaves Lansdown's Mark Dampier calls "a golden opportunity" to buy bonds cheap, especially if slowing growth prompts other central banks to join the Federal Reserve in cutting interest rates. But how do bonds work – and what's the best way in?
Bond basics
A bond is just an IOU, issued by a government ("gilts" in the UK and "Treasuries" in the US), a company, or occasionally by local authorities or other state bodies ("municipals" in the US). But unlike a traditional loan, it can be bought and sold just like a share. There are many different types, but the "plain vanilla" fixed-interest variety is the most common.
The basic principles are pretty simple. You might hand over, say £90 for a 5% three-year bond (often indicated by a date, in this case 2011) paying annual interest payments or "coupons". The "nominal" or "par" value, which determines both the interest you receive and the redemption value, is fixed for the life of the bond. For a sterling bond, this is typically £100. So in return for your £90, you will receive three coupons of £5 and a final £100 from the issuer. That's a total of £15 in coupons and a £10 capital gain. All of this should be reduced, or "discounted", to reflect the fact that £5 received in say a year's time, is normally worth more than £5 received in three years time, taking inflation and lower investment risk into account.
Why buy bonds?
For income-seekers, bonds offering decent coupons are a good option. The commonly quoted "flat" or "income" yield measures the income return by expressing the total annual coupon – many bonds pay this in two semi-annual instalments – divided by the current price. For the bond above the flat yield is £5/£90 x 100 = 5.5%. That could be compared to the return on a cash deposit or the dividend yield on shares. But what about the £10 capital gain (£100 minus 90) also available over three years? The "redemption yield" or "yield to maturity" factors this in by estimating an "internal rate of return" (defined on page 36) for the bond's cash flows. This is a bit fiddly, but there are many online sources of these yields, such as www.bloomberg.com – or an online bond calculator can do the hard work for you. For our made-up bond, the total "yield to maturity" is about 8.95%.
But why pay £90 for that bond rather than £85, £100 or £111? Bond prices are driven by a range of factors but the three key ones are market interest rates, the length of time remaining until a bond is redeemed (or it "matures") and default risk – how likely an issuer is to go bust.
Interest rates and bond prices
Fixed-income bond prices and interest rates tend to move in opposite directions – prices rise as rates fall and vice versa. That's because money market interest rates affect the return you could earn by putting your cash in a savings account rather than a bond. For example, if a cash account offers 5%, but you can buy a 4% three-year bond instead, you'd opt for cash, as £5 a year beats 4% or £4. However, if the 4% bond – remember the coupon is fixed – is available for £91 and the default risk is low, you'd buy the bond. It pays you three £4 coupons and a capital gain of £9, a total undiscounted return of £21 over three years, beating £15 from the cash account. But if the cash deposit rate had been 10% rather than 5%, the bond price would have had to fall below £91 to ensure the overall return stays competitive. So the higher interest rates climb, the lower the price of fixed-income bonds and vice versa.
Maturity dates and bond prices
As a bond approaches its redemption date, its market price tends to move ever closer to the £100 (or €100, or $100, depending on the origin of the issuer) nominal value set when it was issued. That makes sense – if you know a bond will be redeemed next week for £100, you would not expect to buy or sell it before then for much more or less. But if redemption is 30 years away, far more can happen to affect the price in the interim – interest rates could change, or the issuer could go bust.
Bond volatility
Put these two factors together and you get a key risk for bondholders – price volatility. Generally, the lower the coupon and the further away the redemption date, the higher the volatility. That's because we all prefer "jam today", to jam tomorrow. Time, when investing, equals risk. Analysts compare bond volatility using "duration", which captures roughly how far away in years you are from the bond's "midpoint". That's the future date by which you will have received as much cash in coupons as you are still waiting to receive in coupons and redemption value. The further away that point is, the riskier the bond and the more volatile the price.
A related problem is that the inverse relationship between bond yields and interest rates follows a curve rather than a straight line. This "convexity", which varies between bonds, means that even for bonds of similar duration, you can't assume prices will respond the same way to a change in interest rates. For private investors, a solution that steps around having to calculate these sorts of risk is to avoid buying single bonds and just invest in a cheap, diversified product such as an exchange-traded fund (ETF).
Default risk
Some bond issuers are more likely to fail to make repayments than others. The British and US governments are deemed by the credit-rating agencies (Standard & Poors, Moodys and Fitch) to be very safe or "triple-A" rated. As such they can sell bonds at a relatively low "redemption yield" – UK gilts typically offer less than 5%. But riskier emerging market government bonds, such as those issued by Ecuador or Venezuela, have to offer more than double that. It's the same for companies – most are deemed riskier than the UK or US government. Their credit rating, which may range from AAA down to D for "in default" influences the return investors' demand for buying their bonds – the bigger the risk, the higher the yield. And the longer you want investors to risk their capital, the greater this effect.
As for hedging against default risk, professional investors running large portfolios have various options, including buying insurance in the form of credit default swaps (CDS). For private investors this is rarely a possibility, but there are two solutions. One is to stick to gilts and treasuries for safety, but that can mean uninspiring returns. Diversification through an ETF (or perhaps a managed fund) makes more sense. Individual company defaults are rising – insolvency rates are up by 15% on last year, according to the Insolvency Service – but owning a fund reduces the impact of any one default on a portfolio.
Other types of bond
Alongside fixed-income bonds are a host of more exotic instruments – mortgage-backed bonds, eurobonds, convertibles and so on – many of which are too expensive or simply unsuitable for private investors as direct investments. Easiest to access are "index-linked" bonds, which are less volatile than their fixed-income counterparts as they pay a coupon adjusted up or down to reflect an inflation rate. These are a good bet as general prices rise, but will suffer should deflation strike. One way to play index-linked UK government bonds without having to buy individual gilts is via the ishares UK Pound Index-Linked Gilts ETF (LSE:INXG).
What to buy
Although some individual corporate bonds are "attractively priced" says David Roberts, head of investment at Invesco, diversified ETFs are a safer and cheaper bet. For investment-grade UK corporate bond exposure there's the ishares UK Pound Corporate Bond ETF (LSE:SLXX) with an expense ratio of just 0.2%. Safer still, but lower yield is the mixed basket of gilts represented by the ishares FTSE UK All Stocks Gilt ETF (LSE:IGLT). For an ETF that should do well if interest rates fall to support the increasingly fragile eurozone, there's ishares Euro Government Bond 7-10 ETF (LSE:IBGM) with exposure to countries such as Germany, France and Italy. The JP Morgan USD Emerging Market Bond ETF (NYSE:EMB), which, for UK investors in particular, is also a play on the strengthening US dollar, provides a more volatile play on slowing growth in countries such as Russia, Brazil and Turkey.
Finally, state or "muni" bonds in the US are now priced, says Ying Chen Li of JP Morgan Chase, for an "unimaginable" 30% probability that individual states such as California will default in the next 10 years. The ishares National Municipal Bond ETF (AMEX: MUB) is for those who believe that the market is due a recovery.
What is an inverted yield curve?
Among the UK economy's current woes is what Kim-Mai Cutler of Bloomberg calls "an anomaly known as an inverted yield curve", the bond market's way of saying the UK is in trouble. A yield curve plots the individual yields for similar types of bond, say gilts, against time according to their maturity dates. The resulting curve usually slopes "upward" from bottom left to top right, because if you ask an investor to take more risk by buying long rather than short, dated bonds, they demand a proportionately higher yield.
However, yields are not just about how long you have to wait to get your cash back. Other factors include expectations about interest-rate policy. For example, many bond market players – including banks and pension funds – expect rate cuts from the Bank of England to counter a potentially long recession; so long-dated, government-backed bonds carrying a decent fixed coupon suddenly look very attractive relative to cash deposits and shorter-dated bonds. This has already driven prices up and yields down.
Once the yield on long-dated gilts dips below that on short-dated ones, the "normal" curve is said to have "inverted", usually a sign of imminent economic trouble. The yield curve for UK companies often has a similar shape but is usually above the line for ("risk-free") gilts. The gap between the two is known as a "spread". The lower a firm's credit rating, the riskier its bonds and the bigger the spread.
Published in
Investments
| More
articles
by
Tim Bennett
Related articles
-
By Tim Bennett, Jan 31, 2012
-
By Bengt Saelensminde, Jan 30, 2012
FREE - MoneyWeek's daily investment email
Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.