Which Bonds Deserve a Place in Income Investors' Portfolios?

With gilt yields falling - and inflation set to rise - should income investors still consider bonds as part of their portfolios? Morningstar's Dan Kemp says yes - but be selective

Emma Wall 10 February, 2016 | 3:03PM
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Is your portfolio earning you the best possible rate of income? Are you prepared for this year's interest rate rise? We show you how to maximise yield and where to find dividend payers in our Guide to Income Investing.

 

 

 

Emma Wall: Hello and welcome to Morningstar series, "Ask the Expert." I'm Emma Wall and I'm joined today by Morningstar's Dan Kemp.

Hi, Dan.

Dan Kemp: Hello.

Wall: So, so far this year we've seen a gilt yields fall in the U.K. market and this is usually a barometer of what's to come in the rest of the fixed income spectrum. So, I suppose this leads us to the question in our income special week. Do bonds still have a place in an income strategy?

Kemp: Well, Emma, you're absolutely right. Gilt yields have fallen and that is very bad news if you're an income investor and you are buying gilts because you're getting less income than you were before. Now, that's potentially not too bad if we don't have an inflation for the next 10 years. But if we get a return of inflation then that can really hurt someone's real income and of course, that's what we all care about in the end. So, it's bad news for income investors.

But something odd has happened this year in that although gilt yields have fallen, other type of bond yields, particularly junk bond yields, have risen quite a lot. So, we're not seeing a one-way market anymore. We're seeing quite a bifurcation in the market.

Wall: Of course, this just goes to show what we've been learning really since the credit crisis which is that investing one-o-one no longer plays out. Bonds and equities are no longer wholly uncorrelated and markets as a whole don't move together.

Kemp: That's right. We need to unlearn what we've learned over the last 20 years, which has been that typically when equities go down bonds go up and they balance each other out. But that only really works in an environment where real yields, so the difference between interest rates and inflation, is falling and that's happened for a long time now. Well, real yields have got very low and it looks like with this next set of interest rate tightening, higher interest rates that we're seeing, the real yields may start rising again and in that environment then, as you say, this correlation is no longer predictable, you could have falling gilt prices and also falling equity prices, which is very bad for the balanced investor.

Wall: Of course, that doesn't mean that fixed income should no longer play a part in a portfolio because the clue there is in the name, fixed income. They are the one device which income investors have to ensure that they are definitely going to get a certain level of income over certain period of time, aren't they?

Kemp: Absolutely. And they will always be the mainstay of people's income portfolios. But equally when people are investing, they should be thinking from a valuation perspective and the values in the safer bonds these days look pretty poor. So, we'd encourage people to look further afield, some of the high-yielding unloved areas. I've mentioned high-yield bonds, but also emerging market bonds. But remember that these are risky investments. We can have defaults where you don't get your money back at all and that's worse than a low interest rate. So, investors should be casting their net further afield but remembering to get that level of risk right. Don't take more risk than you can afford.

Wall: I suppose it's just quickly worth mentioning before we go about inflation. You mentioned it there at the beginning. Of course, we have had super low inflation over the last year, thanks very much to oil prices falling. But that soon should take out of the inflation measures, shouldn't it, and inflation will need rise?

Kemp: That's why we've had very low inflation for a very long time. We've all become very complacent about inflation and that's one of the reasons why gilt yields are so low. But this is unlikely to continue forever, particularly when we've seen so many central banks around the world trying to promote inflation. It's just possible they will make it happen and they will get the inflation they've been longing for years and in that environment holding fixed income can be a real problem. So, one of the areas to look at is index-linked stock, where your income will rise in line with inflation. Again, not for the whole portfolio, but for a part of it.

Wall: So, as you say, cast your net righter, but make sure you really understand what you're investing in.

Kemp: Absolutely. Fixed income is a very diverse market. It comes with lots of different types of risks. Do your homework.

Wall: Dan, thank you very much.

Kemp: Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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.

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Emma Wall  is former Senior International Editor for Morningstar