Why now is the time to assess bond funds

With just 15 per cent of money held in Isas invested in bond, it’s time that more savers understood what they have to offer.

 

Now that all the General Election buzz is beginning to die down, there’s been much more talk about bond markets. Bonds are an important but often overlooked part of any well-diversified investment portfolio. They provide a series of simple benefits: they pay regular interest (known as coupons) and repay a set amount at maturity. They often perform well when stock markets are falling – so they help to reduce risk. Bonds are considered to be one of the safest asset classes. 

 

That said, fresh volatility has dogged European bond markets this month, with big swings in government borrowing costs hitting share prices. And last week, Goldman Sachs warned that long-dated bonds remain a poor investment. But despite a prominent narrative of global decline, it’s worth revisiting what bonds have to offer.

 

Despite offering a much lower level of risk than stocks, bond markets across the world have enjoyed a spectacular boom since the 1980s as inflation, the great enemy of bonds, has been defeated.

 

Over the last 10 years, UK government bonds have produced an annual compound return of 6 per cent – more than double that from cash, and not far from the 8.3 per cent compound return from the UK stock market. But bonds have also enjoyed a much smoother ride. Looking back over the past 30 years, their worst year was 1994, when they suffered a 7 per cent loss. That compares well against the worst year for stocks, which lost 30 per cent in 2008 – a year in which bonds gained 13.6 per cent.

 

And other riskier elements of the bond markets have produced even higher returns. This includes bonds issued by companies with a poor track record (“junk” bonds), and governments or companies from emerging markets – although the risk profile of these is much closer to shares. 

 

Unfortunately, the UK investing public has missed out on much of these benefits. Only 15 per cent of money held in Isas is invested in bond funds. That may be down to the difficulty in understanding bonds. We find that, while most investors have a good grasp of equities and stock markets, knowledge of bonds is more patchy.

 

The tricky bit is understanding bond prices and yields. The yield is a compound rate you would earn if every interest payment was re-invested back in the bond at current prices, and you held the bond until it matures. Yields work in reverse to the bond price – so higher yields mean that prices are falling, and vice versa.

 

Unlike stocks, bonds are hard to trade directly for the general public. A limited range of 110 corporate and 67 government bonds are available to trade on the London Stock Exchange. This can, however, be useful if you like to hold the bond until it matures, because trading is expensive. Maturity dates can range from a few months to 30 years or more. But for most people, investing in bonds is best done through an actively managed bond fund or an exchange-traded fund (ETF), to spread the risk around many areas and to buy bonds cheaply.

 

While common sense would suggest that bond yields cannot go below zero, more than half of the Eurozone government bonds had a negative yield in April. In other words, investors paid for the privilege to lend money to European governments. 

 

Government bond yields fell through 2014, and even more during part of this year, because of a sharp fall in inflation and the anticipation of bond-buying by the European Central Bank (ECB). We think that government bond markets are overpriced globally, because fears of a period of global deflation, or falling prices, are exaggerated. With improving European growth and a stable or rising oil price, current bond prices are becoming unsustainable. This has already played out over the past month, as investors in the German bond market have lost more than 4 per cent. 

 

These trends have affected the UK to a lesser extent. But with the yield on a 10-year bond at just below 2 per cent, the prospect for high returns from bonds has passed. Rather, we are concerned that bond holders may lose money over the coming years, as the global economy gets back on a firmer footing and yields rise. 

 

We don’t think it’s likely to be a dramatic loss, like it was in 1994 – interest rates are not going up by a large extent any time soon – but we would still take a cautious approach.

 

In our customer portfolios, this year, we have reduced our holdings in government and company bonds, but also made these investments much lower risk, by holding bonds with a shorter maturity time frame.

 

 We still believe bonds pay a useful part in a diversified investment portfolio, but investors need to be aware of the risks that they are taking. If you have been one of the more prudent investors who holds bonds in your portfolio, now is a good time to check the risk of your bond fund.