Why bonds are doomed
The accepted four main assets classes of an investment portfolio to achieve an acceptable diversification of risk are cash, bonds, property and equities. The reason for having these asset classes in a portfolio is because of the diversification of risk and because these assets are considered uncorrelated. In other words, the value of each of these assets should rise and fall at different times depending on factors such as economic growth and inflation. So in other words it is a case of not having all of your eggs in one basket. Such a strategy has served investors well for the last four decades. However, things have now changed.
I think it is important at this stage to clarify what I mean by bonds. I am not talking about the type of bonds issued by banks or Building Societies or National Savings. Nor am I talking about investment bonds which are issued by insurance companies. Unfortunately, the word bond has many different meanings in financial services.
What I am talking about are corporate bonds and government bonds or fixed interest securities. The former are issued by companies, mostly stock market listed companies, and the latter by governments both in the UK and overseas. In the UK government bonds are known as government stocks or gilt-edged securities, gilts for short.
Bonds are loans taken out by companies or governments. They usually pay a fixed rate of interest for a finite period of time though sometimes they are issued as irredeemable stocks meaning there is no end date. Some government bonds are index-linked.
Companies may issue bonds instead of issuing more shares for various reasons. Usually, the money is raised for a specific purpose such as providing funds to buy another business, to provide working capital or to replace existing more expensive debt. Governments, especially the UK one, borrow money by issuing government bonds annually because they spend more than they receive in tax receipts annually. This is known as the Public Sector Borrowing Requirement or PSBR for short. In my entire adult life, I have never known the UK government to spend less than it receives in a year apart from a short period during the seventies under the Thatcher Conservative government.
In November 1979 the base rate in the UK reached a record high of 17%. In March 2020 the base rate reached a record low of 0.10%. So the base rate fell for 40 years. During this period the value of bonds rose. Why? Well, curiously the value of bonds has an inverse relationship with the level of interest rates. So when one rises the other falls. In other words, there is a seesaw effect.
It is so long since the base rate rose that most people have forgotten what happens to bond prices under this scenario. Unfortunately, investors will soon be reminded what is coming next because the base rate cannot fall any further unless it goes to zero or even a negative rate which I consider highly unlikely. Already the US has announced it is abandoning any efforts to control inflation. When inflation returns, and it is a matter of when not if, interest rates will have to rise to combat it. This is an inevitable consequence of the long term economic cycle of 50-75 years and it has been repeated continuously over the last 5,000 years as long ago as the Chinese dynasties.
Bonds will then start to fall in value. Things could turn quite nasty for bond holders including most individuals who hold them in their diversified investment and pension portfolios which are invested in the four main asset classes of cash, bonds, property and equities. It could become so bad I would not only urge all bond investors to seriously consider divesting their portfolios of bonds altogether but to not touch bonds for a considerable period of time, possibly decades.
What are we doing at Wealth And Tax Management? We will write to all of our clients shortly to advise them to disinvest from bonds. 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.