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It could be a lot harder to make money from the bonds space next year
Thursday 17 Dec 2020 Author: Martin Gamble

Bonds are often considered an integral part of a portfolio by providing diversification and, in many cases, adding a lower risk element to someone’s investments. Unfortunately, many bonds have become unattractive due to prices being bid up and yields falling. As such, investors need to be very careful where they put their money in the fixed income space in 2021.

This article explains the basics of bonds and looks at the main parts of the market to see which look attractive or not.

WHAT ARE BONDS?

Bonds are IOU’s issued by governments and companies to investors in return for cash. They usually have a fixed life, called the maturity, and offer different levels of interest, called the coupon. Generally, bonds get issued and redeemed at par, or 100.

Because the coupon is fixed bonds don’t provide any income growth potential if held to maturity date, unlike shares. However, prices can move up and down during the life of the bond, so there is scope for capital gains and losses.

While bonds are designed to offer a more secure return than stocks, depending on the financial health of the issuer, they do not provide any protection against inflation. That means the purchasing power of the capital an investor receives back at maturity may be lower, especially over longer periods.

Bond prices move in the opposite direction to yields.

Current state of the bond market

Government bonds – unattractive if you believe economic growth will be strong in 2021.

Investment grade corporate bonds – demand has been strong this year, so yields are relatively low on investment grade bonds.

High yield corporate bonds – yields are more attractive in this space but still much lower compared with a few years ago. Don’t forget the greater risk of corporate defaults.

LIQUID MARKET

The global bond market is probably bigger than most people think and is worth $128 trillion according to data by the International Capital Market Association. Government or sovereign bonds make up around at $87 trillion which is twice as large as the corporate market of $41 trillion.

Since the financial crisis more than a decade ago, interest rates have fallen and in several cases government bonds in Japan, Europe and other countries have negative yields.

This means that if investors hold certain bonds until maturity, they will guarantee a loss.

It’s working explaining how that would work in practice. Let’s say an investor buys a bond at 115. Because the bond matures at 100, if the interest payments received while holding the bond don’t fully compensate for the 15 points of loss, an investor will make a negative return.

That doesn’t stop many investors buying such products, as they see benefits such as the potential to make a capital gain if sold before maturity and as a hedge against deflation.

CURRENCY RISK IS SUBSTANTIAL

When considering investing in foreign bonds it is important to take the currency into account because even small changes in the exchange rate can easily wipe out returns when interest rates are very low, like today.

That’s one of the reasons it is easier and safer to invest in bonds via active or passive funds which automatically hedge foreign exchange risk.

Another reason is that analysing government bonds or corporate credit requires specialist skills which are beyond the reach of the typical investor.

GOVERNMENT BONDS CURRENTLY UNATTRACTIVE

Shares spoke to various bond managers for this article and they all had a negative view on the prospects for government debt. This because a strong economic recovery is anticipated next year thanks to vaccinations gathering pace as restrictions are pared back.

The central view is that an anticipated $1 trillion US fiscal stimulus combined with a commitment by the Federal Reserve to keep interest rates low will spur a faster recovery.

Growth is generally bad for bond prices as yields tend to rise during periods of strong growth.

Not only do government bonds offer virtually no interest – UK government bonds have negative yields out to five-year maturities – they also risk capital loss as the yield curve steepens.

This refers to longer-dated bond yields rising more than shorter-dated issues. Prices of longer duration bonds are more sensitive to interest rate rises  and inflation.

CORPORATE BONDS

Corporate bonds are sometimes referred to as credit investments because most of the risk attached to them is related to the financial strength of a company.

Credit ratings for companies are not dissimilar to your own credit rating and reflect the ability to service debts.

Credit rating agencies such as Standard and Poor’s, Moody’s and Fitch provide credit research and bond ratings and the best quality companies are given an investment grade rating.

Non-investment grade bonds are called high yield or junk, reflecting their lower credit quality.

A study by S&P showed that companies at the bottom of the investment grade ladder (BBB) had a 0.16% chance of defaulting compared with a 27% default rate for the companies rated at the bottom of the junk or high yield category (CCC).

It’s customary to refer to different credit rating categories by the extra yield they offer over safe government bonds, called the spread.

TIGHTER CORPORATE BOND SPREADS

There is very little risk priced into corporate bonds which would make them vulnerable to another dip in the economy.

Since the US Federal Reserve made the move to include investment grade corporate bonds in its asset buying programme in late March, there has been a torrent of new issues while yields have fallen below pre-Covid-19 levels.

The yield on US investment grade corporate bonds has dropped from 5.6% during the panic in March to 2.1%. This represents a spread of 1.2% over 10-year government bond yields of 0.9%.

The $56 billion iShares iBoxx $ Investment Grade Corporate Bond ETF surged around 30% from the trough in March to the recent peak, yet investors have since been taking profits with the fund seeing its biggest ever single day outflow in the second week of December, which saw redemptions of $1.3bn.

Investors looking for extra yield are reduced to considering the riskier high yield corporate debt market. However, yields and spreads are near historic lows with the US spread is around 3.6%, while in Europe it is 3.4%.

Investors going down this path should be mindful of what bond fund manager Dan Rasmussen called ‘fool’s yield’ which refers to the extra yield seemingly on offer which fails to materialise because defaults are higher than expected.

OUR PREFERRED WAY TO GET EXPOSURE TO BONDS

Given the unprecedented nature of the past year, and the huge debts taken on to survive the pandemic by governments and corporations, there is a lot of uncertainty around the speed and extent that the global economy will get back to pre-Covid-19 levels.

The dispersion between positive and negative outcomes is very wide. For instance, Moody’s has a best-case scenario where credit defaults fall to 4% next year while its worst case has them accelerating to 18% by next September.

Therefore, a good case can be made for considering tactical bond funds which have the flexibility to take advantage of opportunities across the full spectrum of bonds and actively manage risk.

Henderson Diversified Income Fund (HDIV) BUY

Price: 88.8p

Market Cap: £170 million

Discount to NAV: 4.2%

Yield: 4.95%

Managed by industry veteran John Pattullo and Jenna Barnard, this investment trust has a unique investment approach focused on lending to quality businesses which makes the portfolio more durable should the economic backdrop deteriorate.

The trust has an excellent track record, delivering a five-year average annual return in NAV of 6.6% compared with 4.7% for the Morningstar category.

The managers see corporate bonds as the best area for yield because they believe the bond ratings downgrade cycle has peaked, creating a more benign outlook for defaults.

The trust is attractively priced and trades at a 4.2% discount to NAV compared to a 12-month average of 2%, while offering almost 5% historic yield.

Examples of ways to invest in bonds

UK GOVERNMENT BONDS

Lyxor FTSE Actuaries UK Gilts UCITS ETF (GILS)

Price: £150.40

Market Cap: £690 million

Yield: 2.23%


UK INVESTMENT GRADE CORPORATE BONDS

Artemis Corporate Bond I Inc GBP (BKPWGV3)

Price: £1.10

Market Cap: £493 million

Yield: 1.89%


GLOBAL BONDS

M&G Global Macro Bond GBP I Inc (B78PH60)

Price: £ 138.53

Market Cap: $2 billion

Yield: 2.1%


HIGH YIELD BONDS

Baillie Gifford High Yield Bond B Inc (3081671)

Price: £135.50

Market Cap: £ 830 million

Yield: 4.3%


STRATEGIC BONDS

Artemis Strategic Bond I Quarterly Acc (B2PLJR1)

Price: £1.10

Market Cap: £1.7 billion

Yield: 2.4%


EMERGING MARKET BONDS

M&G Emerging Markets Bond GBP I Inc (B4TL2D8)

Price: £128.98

Market Cap: $1.1 billion

Yield: 6.4%

Source: Blooberg

Please these are 12-month historical yields and may not be representative
of the yields you would get today.

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