Despite rising interest rates and the threat of inflation bringing potentially negative winds for bond investors, Brian Tora argues that it is too early to write off bonds just yet
It is remarkable how much has changed in the world of investment over the years. When I started out in this profession more than half a century ago, the choice available for investors was very limited. UK equities, British Government Securities (or gilts as they are commonly known) and cash were about the extent of the investing landscape. True, overseas shares were available – mainly through trusts as this was when the investment dollar premium existed which penalised those who wished to place their money abroad.
The evolution of choice
Perhaps of most significance was that few private investors placed any part of their portfolios into corporate bonds. These were viewed as options only really suitable for the professional investor, such as pension funds and insurance companies. It did start to change – slowly. Imperial Chemical Industries, then one of Britain’s largest companies, launched two bond issues in the mid-1960s. Though not specifically aimed at private investors, they did attract a great deal of attention from individuals seeking to enhance their income.
Life turned tricky for bond investors in the 1970s. Rampant inflation and a major recession saw corporate failures and sky high fixed interest yields drive bond values ever lower. Not that it was much of a picnic in the equity stakes. The combination of the oil price quadrupling, the three day week and a secondary banking crisis during the 1972/74 period saw share values fall by 70% peak to trough in this country, making it the worst post World War II bear market. The recovery for shares was relatively swift, but bond investors had to wait quite a while for their fortunes to improve.
Where are we now?
Fast forward to the present day and bonds are now an integral part of many investors’ portfolios. Moreover, the nature of bond investment has changed out of all recognition. There was no such thing as a fund enabling a private investor to spread his or her assets between a variety of bonds when I started out. Today the Investment Association has several sub-sectors within the bond fund universe which provide an opportunity to select a particular style of investing, a geographical bias or a risk based approach to portfolio construction.
There was no such thing as a fund enabling a private investor to spread his or her assets between a variety of bonds when I started out
The simple measure of investment returns, epitomised in the Barclays Equity/Gilt study which looks at investment trends and results back to the end of the nineteenth century, has suggested that equities always outperform bonds over the longer term – until recently, that is. The financial crisis of a decade or so ago, which ushered in a sustained period of very low interest rates coupled with muted inflationary pressures, allowed bond investors to prosper. The growth and development of bond fund managers created an opportunity for all to benefit from what is, after all, the dominant securities’ market globally.
Looking ahead – should we be worried?
But things are changing. In the US interest rates are already rising. Money is becoming tighter around the world. Inflation, proclaimed dead by leading economist Roger Bootle in the wake of the concerted action by central banks to stave off the worse consequences of the financial collapse, may yet rear its ugly head. Against such a background, can bonds still be viewed as the core asset class they have undoubtedly become?
Much attention is being focussed on America right now. A buoyant US economy, rising wages and asset price inflation has led to the Federal Reserve Bank raising interest rates steadily. So far the main casualties seem to have been emerging markets, but with US Treasury yields forging higher, there are growing concerns that interest rates may have further to rise. And a rise in the cost of money means higher yields on fixed interest securities, which in turn pushes capital values lower.
So the outlook for bond funds looks, at the very least, to be uncertain. But it is too soon to write them off as an asset class. While central banks reining in their quantitative easing programmes suggest that we could return to a more normal interest rate structure, there are sufficient uncertainties around the world to realise that maintaining economic growth could take precedence over monetary tightening, thus taking the pressure off bond yields.
Also, interest rates vary greatly from country to country and from one class of bond to another, while the options open to bond fund managers are vastly greater than used to be the case. Index-linked bonds are now part of the mix and derivatives allow hedging techniques to be put in place where the terms of a fund permit it. Managers can also vary duration within their portfolios to help protect themselves against interest rate trends.
The outlook for bond funds looks, at the very least, to be uncertain. But it is too soon to write them off as an asset class
Today we have large fund management organisations specialising in bonds, while most fund management groups will include a fixed interest element in their mix of products. And bonds remain a safety play for when a risk-off strategy looks prudent. The important thing is to realise that bond funds can vary greatly in terms of investment approach and likely outcomes. Careful research is just as important here as with equity funds.
Brian Tora is a consultant to investment managers, JM Finn.