Should You Bother with Bonds?

VIDEO: Morningstar's Dan Kemp explains which areas of fixed income have held up well in recent sell-off, and why some have disappointed

Holly Black 30 March, 2020 | 1:31PM
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Holly Black: Welcome to Morningstar. I'm Holly Black. With me is Dan Kemp. He is Chief Investment Officer at Morningstar Investment Management. Hello.

Dan Kemp: Hello, Holly.

Black: So, we are talking fixed income today because I think people usually expect the fixed income part of their investment portfolio to protect them when the stock market's fallen. And that hasn't really happened this time. So, can you explain why that is?

Kemp: Yes, absolutely. So, I think the first thing to remember is that fixed income can refer to a huge array of different securities from what we think of as very similar to cash in the bank, through to loans to governments, which could be over almost any time period, right along to loans to companies that are very secure and at the far end to companies that are quite insecure financially or to a particular project. So, when we say fixed income, you have to be really clear in what we're talking about. Because while some of those assets typically protect people in a market downturn, others are quite closely correlated to the economy, quite closely corelated to the stock market. And having the wrong type of fixed income can cost investors dearly.

Black: So, have some types performed better than others in the past couple of weeks?

Kemp: Well, this has been a very unusual period, because normally, we'd expect government bonds to be the most secure and the most likely to protect your capital and they have in the main provided you've been holding government bonds or loans to governments in the developed countries, so the UK, for example. But even in those markets, we've seen very large price swings over the last couple of weeks. And at times, the price has fallen quite dramatically. So, they haven't been the solid support that investors maybe expected. Cash has often done better. So, yes, some bonds have helped investors in this period. Other bonds have really collapsed in price, as people are concerned about the ability of companies to pay back their debt over the last couple of years.

Black: Yeah. So, obviously, the fear of an increasing company defaults makes lending money to companies perhaps less attractive. But does the avalanche of government spending that we're seeing make the governments now less appealing to lend to?

Kemp: Well, that is one of the great uncertainties of investing at the moment. So, we're obviously supportive of government measures to try and get the economy back to normal over the coming months and years. But that undoubtedly comes at a cost and we don't know what the cost of that will be at all or who it will fall upon. But yes, you're right that it looks like government borrowing will increase, and that will have some sort of impact further down the line. But even before that, we have to acknowledge that government bonds are at very low yields at the moment. So, it is a question about how far people are prepared to go to lend governments money at very, very low interest rates. Whereas conversely, what we've seen in company bonds, so debts that companies have or loans we've made to companies, we've seen the yields of those rocket. Now, that's meant the price has fallen, but potentially that's a much more attractive investment opportunity for people right now.

Black: So, though the prices are falling, and these aren't quite maybe providing the protection I'd hoped, does that mean I just shouldn't bother with fixed income?

Kemp: It's really important that fixed income is a part of most people's portfolios. But it's important to know why you own fixed income. We've talked before about fixed income. And as you know, we've been concerned about the prices of some fixed income. We've been concerned that people have been overpaying for some of these fixed income securities which wouldn't hold up well in this type of prices. Whereas now we're in a different situation where because prices have fallen so far, arguably, these securities offer a much better bang, but it's really important, as I say, to know why you own fixed income in a portfolio. Is it simply because you're hoping that it will be negatively correlated to equities? Or does it provide a return in itself? As ever, diversification in your portfolio and understanding why you own not just what you own is really important.

Black: So, are there any areas that you think look to be more appealing than others at the moment?

Kemp: Well, yes. Most parts of the fixed income market are more appealing than they were a few weeks ago. As I mentioned, government bonds look extremely expensive. But when we get to corporate debt, it's looking more attractive. When we get to what's called high yield, sometimes called junk or sub-investment grade bonds, they're really a lot more attractive than they were a couple of weeks ago. And so, in that type of market, you have to know what you're doing. You have to trade carefully. Because the fact that these bonds are offering such high yields, it means that probably some of them will default in the current economic circumstance. So, you want a good guide if you're going to invest in that type of market, potentially a good fund manager to run that particular portfolio for you. But certainly, we're seeing some opportunities in that part of the market.

Black: Dan, thank you so much for your time. For Morningstar, I'm Holly Black.

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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Holly Black  is Senior Editor, Morningstar.co.uk