There are a few good reasons to hold bonds in a portfolio. They can provide a steady and reliable income. They can offset the inherent volatility of the stock market, rising when shares fall and vice versa. Depending on who has issued the bonds, they can provide capital security - the US or British governments, for example, are unlikely to default. If interest rates fall, simple arithmetic means they will deliver a capital gain because their fixed income stream becomes more valuable to an investor.
All of these are true but, with the exception of the dependability of the governments on either side of the Atlantic, none of them is particularly relevant today. While it’s true that the income from bonds can be reliable, it is also pitifully low if you are not prepared to take the credit risk of a company failing. If you are, then you are better off receiving a possibly higher, and probably growing, dividend income from the same company’s shares.
While it is also true that in the past bonds have offset the ups and downs of shares, this is less likely with interest rates and yields at today’s low levels. The thinking behind the traditional 60/40 fund, with a mixture of bonds and shares, remains hard-wired, but the reality is that the best days for these balanced portfolios is now in the past. Were inflation to kick off, it is probable that both bonds and shares would fall at the same time.
The third advantage, the capital gain achieved as interest rates fall, also seems purely theoretical in today’s environment. The recent meetings of both the Federal Reserve and the Bank of England made it clear that the next move in interest rates will be up, and probably within the year on both sides of the Atlantic. So, the arithmetically automatic gain is more likely to be an automatic loss in the months and years ahead.
The situation for corporate bonds is, if anything, worse than for government debt. That’s because the search for yield by income-starved investors has seen the gap between government bond yields and those on corporates narrow to historically low levels. The spreads, as they are called, have never been tighter. That means that if bond yields rise, fixed income investors could be hit by a double whammy - a rising risk-free rate and a wider spread at the same time. The combination of the two would deliver a sharp fall in bond prices.
Bond investors are pinning their hopes on at least one of three things coming to pass. They need a combination of pension fund regulation and the desire for income to keep money flowing into bonds. They hope that government bond issuance will fall back as quickly as central bank bond purchases to keep the arithmetic of supply and demand intact. And they believe that inflation will prove as transitory as central banks seemed to think until very recently.
All of these are possible, but the risk/reward balance still leans much more to shares than to bonds.
Important information: There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall.
The raw material rollercoaster
Source: Refinitiv, 30.9.21, rebased to 100 as at 30.9.19, total returns in USD
(as at 30 Sept)
|Oil (Brent Crude)||14.1||43.4||-26.5||-32.7||91.7|
Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may affect the value of your investment.
Here’s a trick question. If you had invested in iron ore, gold and oil two years ago, which of the three would have delivered the best return? The answer is clear from the chart above, but you would otherwise probably not have guessed it: none of the above. That’s because the three commodities have all taken very different routes to arriving at pretty much the same place.
If you had read the recent headlines you might have plumped for oil. The price of Brent crude has certainly risen strongly recently to above $80 a barrel for the first time in three years. But that has merely unwound the dramatic collapse in the oil price at the start of the pandemic in early 2020. And oil is still considerably cheaper than it was six or seven years ago.
Iron ore has taken a different sort of round trip, more than doubling since last autumn on hopes for a global economic rebound but then halving again as China’s clampdown on property speculation and the woes of Evergrande raised questions about demand for steel, for which iron ore is the key ingredient.
And what about gold? Well, it has bounced around for a year or so between $1,700 and $2,000 an ounce, seemingly unsure whether resurgent inflation would increase demand for the precious metal as it has in the past or leave it playing second fiddle to the new kid on the block, bitcoin.
Watching commodities this year has been exhausting and for most investors it’s all been a bit too volatile to make sense as an investment class other than via a broad-based basket of resources that evens out the differences. The bigger concern for investors is what impact rising prices will have on corporate earnings. A surge in energy prices is top of the list of worries.
About two thirds of the total return from real estate is accounted for by the income it delivers to investors. That means that assessing the quality of a property’s tenant is just as important as how good a building is or where it is located. In a world that’s changing as fast as ours, with widespread disruption of business models, it’s arguably more important.
This is where your choice of fund manager comes in. A boutique property investor may have a good understanding of where rental yields are heading and where investment fund flows are coming from. But they may be behind the curve when it comes to the trends that will affect the durability of a tenant in a particular sector - whether they will continue to pay their rent, or indeed survive for the duration of a lease. This is why a cross-functional approach to property is so important. Property expertise needs to be balanced by a fixed income-like approach to due diligence and an equity analyst’s eye for changing themes.
Property has a place in a portfolio, especially in a more inflationary world where rising rents can help real estate investors keep up with rising prices. But as a wall of money continues to drive yields to historically unprecedented levels, knowing your tenant has never been so important.
Important information: Funds in the property sector invest in property and land. These can be difficult to sell so you may not be able to sell/cash in this investment when you want to. There may be a delay in acting on your instructions to sell your investment. The value of property is generally a matter of a valuer’s opinion rather than fact.