The perils of bonds and how to avoid the risks

In my early December blog entitled Why Bonds Are Doomed, I explained why I was so pessimistic about bonds and why you shouldn’t invest in them.  In this blog, I am going to expand on this theme.

Bonds, by which I mean gilt-edged securities, otherwise known as government bonds and corporate bonds which are, as the name implies, issued by companies, normally publicly quoted companies or PLCs.  Investors in bonds are in fact lenders. Lenders to governments and companies. No different to bank depositors who are nothing more than lenders to banks. Of course, all of these borrowers are benefiting from record low-interest rates. Unfortunately the same can’t be said of investors who are getting a very poor deal indeed.

The risks are different depending on whether you consider corporate bonds or government bonds. It is across the wide range of corporate bonds that there are the biggest risks – because companies are at risk from the economic cycle, whereas governments/central banks can (for quite a while) persist in printing money to keep them out of trouble and push away difficult decisions.

In a nutshell, companies have been exploiting very cheap rates, and borrowing money through issuing bonds. A significant proportion of the money raised has simply been used for financial engineering – which is a polite way of saying that a lot of executives have been able to line their pockets.

This has been enabled by the actions of (unelected) central banks, with considerable electoral consequences, which are very far from over – but that is not our issue right now. Here we just need to be clear that this asset class is in trouble. 

The Bond History

Before jumping into any asset class it is good to get a long term picture of the trend and its ups and downs.

Chart 1 shows consol bond yields in the UK from 1750 to date. ‘Consol’ is another word for perpetual, so these bonds have no maturity date.

Between 1750 and 1970, interest rates varied between 2% and 5% before surging to around 17% in the mid-1970s as inflation took off.  As inflation was gradually tamed in subsequent years, in tandem there was a multi-decade fall in interest rates – with interest rates and bond yields falling, this meant chunky capital gains from bonds. 

As you can see in the chart, today bond yields are at a historical extreme.

Looking at the long term chart again, it seems logical that the only direction for interest rates is up – they may fall a bit further in the short term, but we’re now playing at the end of a very long cycle. If interest rates and bond yields were to increase, bond prices will fall resulting in capital losses.

There is the added problem of the lack of liquidity in the bond market. If you want to sell your bonds, who is going to want to buy them if interest rates are heading up? It could get ugly.

 

*Past performance is not a reliable indicator of future results

 

Looking Forward

As can be seen from Chart 2 below, GMO has crunched the numbers for various types of bonds and the suggestion is annualised returns after inflation of between -0.8% and -4.4% in the 7 years ahead.

 

Chart 2: Bonds 7-year real return forecasts by GMO.

*Past performance is not a reliable indicator of future results

GMO is not alone.

JP Morgan’s 2021 Investment Outlook states that:

“with such low starting yields, government bonds offer little income or upside potential and it’s time to rethink the 60:40 approach to portfolio construction”

Steve Blumenthal, a bond specialist, puts it more bluntly:

“there is the mother of all bubbles in the bond market”

He projects 70% falls in high yield bonds, though is very excited about the opportunities at that point – as am I.

So how do you now avoid the perils of bonds?

If you are invested in a traditional diversified portfolio of equities, bonds, property and cash such as the Parmenion Strategic Passive portfolio which many of our clients are invested in, you have a number of choices.

  1. Increase your attitude to investment risk to risk grade 9 or 10.  At this level you will invest proportionately more into equities and zero in bonds. 
  2. If you have a portfolio worth at least £250,000 consider switching to our Transact Discretionary Fund Management service managed by our associated company Minerva Money Management as long as you have an attitude to investment risk of at least 7.  Our DFM service does not invest in bonds currently.
  3. If your attitude to investment risk is level 6 or less then consider increasing it by say one or two grades e.g. 4 or 5 to 6 which will at least reduce the amount invested in bonds.
  4. If you wish to remain at risk grade 6 or less and you are already invested 20% in the CCM Intelligent Wealth Fund as part of our Wealth Investment Strategy, WIS, an 80:20 core-satellite strategy, why not consider changing it to 70:30 by increasing your investment in the fund which doesn’t invest in bonds?  
  5. If none of the above applies you can simply change your selected Parmenion strategy to one that either doesn’t invest in bonds or one that invests less in bonds than Strategic Passive.

 

Fortunately, there is no sign of interest rates rising in the short term and, of course, there is an outside chance that the base rate could fall into negative territory for a while.  If that were to happen then bonds could have a short term reprieve and their value could rise.  Nonetheless, this is unlikely to be the case for very long.  The truth is the prospect of rising inflation is increasing and with it the spectre of rising interest rates which will be the death knell for bonds. 

As you can see there are a plethora of solutions to the bonds dilemma. The key is to take action and not sit on your hands.  So do get in touch with us for advice or wait until your next annual review meeting to discuss your investment strategy. You know it makes sense**.

 

**The contents of this blog are for information purposes only and do not constitute individual advice. All information contained in this article is based on our current understanding of taxation, legislation and regulations in the current tax year. Any levels and bases of and reliefs from taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future. Although endeavours have been made to provide accurate and timely information, we cannot guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future.