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Why Bonds Matter

Morningstar Investment Management's Mark Preskett looks at the role of bonds in an investor's portfolio and what they mean for the wider economy

Mark Preskett 4 April, 2019 | 2:52PM

currencies

You might be wondering what all the fuss is about bonds at the moment. Let’s face it, bonds rarely dominate the headlines. Yet, with recession risks rising, many are looking to the bond markets for clues and protection.

In this sense, we should first offer perspective. Fixed income markets have enjoyed one of the greatest 30- to 40-year bull markets in history. With bond yields falling from highs of over 15% in the early 1980s to lows of around 1% today, the asset class has delivered unprecedented outcomes for cautiously minded investors on a risk-adjusted basis. In many ways, fixed income has been akin to the world’s greatest defence, with an ability to score goals (deliver returns) and never concede (rarely suffering downside risk).

The challenge is that the next five, 10 or 30-40 years may not be the same. Some have even likened it to picking up pennies in front of a steamroller. So, given this dynamic, why do bonds matter and how can they help you? We set out three key pillars of thought below, hopefully highlighting the compelling story of opportunity and risk management.

How Bonds Can Help:

1: As a Source of Income

Bond investing is conceptually quite simple. A government or company needs to raise capital, so will issue bonds at a fixed rate of interest. This rate depends on the quality of the company (a higher risk corporate will need to pay higher rates to compensate for risk) and the time horizon they want the money for. So, as an investor, you can lock in the current rate and — assuming you are willing to hold for the full maturity — will get your money back along with the income along the way.

As an investor, the key is to focus on three variables: 1) the rate of income on offer, or the yield, 2) the length of the contract, or duration, and 3) the riskiness of the counterparty, or credit quality. These will all impact the price of your bonds over time.

The notion of quality should not be underestimated here, as we’ve seen a significant uptick in lower-quality corporates raising capital via bonds. In fact, BBB-rated issuers — those just one notch above so-called junk status — now accounts for around half of the whole investment grade market in the US and Europe.

There are several reasons for this. To name just a few, firms are using debt to fund acquisitions, carry out stock buybacks and make dividend payouts. For multi-asset investors, like ourselves, this means prudence must be applied when buying corporate debt, where we favour higher-quality investment-grade investments.

2: As a Diversifier

One of the great features of holding bonds is that they bring something different to the table. For instance, during a stock market crash, bonds are reputed for their ability to offset equity losses. This occurs because the majority of investors don’t buy bonds directly, and thus, make profits in the secondary market as their protective assets become more valuable. It is this ability to buy and sell in a secondary market where the diversification benefit is obtained.

To be effective though, it is important to differentiate between government bonds and corporate bonds. The trouble with corporate bonds is that the underlying cashflow risks often share commonality with stocks. For example, if a company goes bust, both the stocks and the bonds of that company will fall. Government bonds tend to be the more protective of the two during market panic for three key reasons: 1) they are considered to have little to no default risk and offer a lot of liquidity, therefore benefitting from a ‘flight to safety’, 2) the rates on offer tend to be tightly linked to the health in the economy, benefiting if interest rates get cut, and 3) they often involve longer holding periods, which increases the sensitivity to changes in interest rates.

It is these government bonds which can still play a role in portfolios, although stretched valuations can temper this judgement. For instance, lending money to the U.K. government will now give you less than 1.0% over a 10-year period despite the political turmoil amid Brexit.

Investors should however be aware of the multiple factors at play which have been keeping a lid of bond yields. Demographic changes like the aging population and longer life expectancies, higher savings rates in emerging market economies, and technological advances have all been cited in studies to justify rates staying lower for longer.

While we remain cautious in taking duration risk in our portfolios (generally favouring shorter-dated bonds), we see many reasons for a more benign interest rate environment over the medium term and have recently adjusted our fair yield levels down as a result.

3: As a Recession Signal

Recent headlines have been dominated by the concept of “yield curve inversion” and recession risk. The reason the media are running with this story is because the track record is quite compelling. That is, bond markets have historically offered a useful signal of recession risk during rare but specific periods. We are now in the midst of one of these periods — at least in the US market — raising concerns about everything from jobs to stock markets.

To track this yourself, it is important to follow the government bond markets (the data is publicly available) over different maturity dates. For example, say the U.K. government needs to borrow £1 billion via bonds, you have the opportunity to lend them part of this amount at a yield of around 1.0% over a 10-year period or 0.8% over a 2-year period. If the rate over longer periods is lower than for shorter periods, this is thought to be a useful barometer that recession risks are rising (because people believe rates will be cut into the future).

The real question here is whether bond investors have predictive abilities over the economy or markets. When it comes to managing a portfolio, we only really care about the markets, where the relationship is tenuous at best. It is useful to understand risk, but not something that directly impacts our investment decision making.

Picking the Right Bonds to Support a Portfolio

At this juncture, it is healthy to remind ourselves of the two key roles lower-risk bonds play in a portfolio: 1) as a source of return, and 2) to diversify equity risk. Like any asset, the risk and reward for bonds evolves over time, subject to changes in levers such as rates, quality, duration and liquidity; to name a few. It is therefore important to keep your finger on the pulse, where we find a troubling mix of lower yields with higher risk.

If we go back to the defensive analogy in sport, we know that a well-constructed team requires a mix of strikers, midfielders, and defenders. For government bonds, they may not offer much by way of attack (poor long-term return prospects due to the low rates on offer) but have had an ability to hold up defensively when called upon (especially if stocks sell off). The key is to consider the opportunity set holistically and not rely on any one player.

Balancing this, we tend to find our portfolios have a greater weight towards those assets we believe can best withstand the headwinds. These includes bonds with shorter time horizons (lower duration risk), higher rates or yields (greater income) and higher credit quality (downside protection). Otherwise, we prefer to hold healthy levels of cash, offering ammunition should conditions worsen. As ever, risk and return must always be weighed in unison.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Mark Preskett  is a Senior Investment Consultant & Portfolio Manager for Morningstar UK                       

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