I started off writing about Position Sizing but got a bit sidetracked due to the inclusion of Bonds within the sizing discussion. I have consequently written my view on Bonds at the moment.
Bonds are an Asset you can buy that pays you a Coupon. You are effectively lending money to the Bond issuer (the borrower) and they pay you back the value of the Bond at the end of the Agreed Life of the Bond (the Maturity) - assuming all goes well and they remain solvent. In addition, you get paid the Coupon every year up to Maturity. In a way you can think of it like a Share with a Dividend - but the Share has the potential to provide a rising dividend payment and Capital Gains. If held to Maturity, a Bond will only pay back the purchase value and you will have received the steady Coupon payment each year.
Once the bond is issued, it usually is ‘Tradeable’ - i.e. it can be bought and sold on the market. This means that the Price of the Bond can go up and down and therefore the % of Coupon Yield will vary.
For example, say a Bond is issued at 100p with a Coupon of 5p for 10 years. Obviously, at Issue, the % yield per year is 5% (5p/100p expressed as a percentage) and if you hold to Maturity, the full 10 years, if all goes well you get your 100p back and you will have received 10 lots of 5p over the years on top.
Now, let’s say you decide to sell your tradeable Bond in the market after 2 years because you desperately need some cash (not sure you can buy much with 100p these days !!) - but in the meantime from the Issue Date the level of interest rates set by the Central Bank has risen. In this case, the yield needs to rise to make the Bond attractive to buyers - so let’s say it now yields 7%. In order to yield 7% the price would need to fall from 100p to 71p (I worked this out fast on a calculator by trial and error) - i.e. 5p/71p gives 7% yield.
From this example, you will hopefully realise that Bond Prices and Bond Yields are inverse - i.e. if the Bond Price goes up, the Bond Yield must fall and if the Bond Price goes down, then the Bond Yield will rise.
Bonds come in various different types but the main ones are Government (Gilts in the UK, T-Bills in the US, Bunds in Germany and OATs in France I think) and Corporate - issued by Companies. Bonds are generally believed to be safer than Shares but this varies between Government and Corporate and then there are varying levels of risk within these broad groupings. There are other types of bonds which are very specialist in nature - for instance Social Impact Bonds, Insurance Catastrophe Bonds, Mortgage Bonds, etc.
Bond Ratings Agencies analyse a particular Bond and give a grading depending on factors such as Perceived risk of Default (i.e. not paying it back), Maturity, History of Issuer, Economic factors etc. etc. These range from AAA for the Top Rated countries down to Junk Bond status which are seen as very high risk and are usually from Corporate Issuers I believe, although perhaps the likes of Greece and Argentina would be classified as such. You have probably heard about Ratings Agencies doing downgrades on the UK and various European countries - the well known ones are Standard & Poors, Moodys and Dunn & Bradstreet.
I think I have gone well off track here but I think it is useful to have a high level appreciation of Bonds. Many people buy Bonds and have no clue about what they are really buying.
So, why am I going on about Bonds you ask? Well, what I was coming to is that even though conventional wisdom is that Bonds are safe, low risk investments, I think we are at a very unusual period of history where Bond Prices have risen too far over 30 years and Bond Yields have tumbled. For instance, a 2 year German Bund yields around 0.8% - would you lend cash to the German government for a paltry 0.8% per year with all the issues in the Eurozone? Especially as you can get far higher returns by taking on only a slightly higher risk.
When Interest Rates in the wider economy rise, as must start to happen in 2015 for UK and US I imagine, the Yield on Bonds will need to rise - and as we discussed earlier, when Bond Yields rise, Bond prices must fall. If you buy a bond and hold it to maturity, you will not suffer a Capital Loss when the Bond is redeemed and you will have had the Coupon payments - however, in Real Terms with possibly higher inflation, you will have lost out (you can get Index Linked Bonds which pay a higher or lower Coupon depending on Inflation which would avoid this). You may also have lost out in terms of Opportunity Cost - if your money had not been tied up for 10 years in that low yielding Bond, you might have been able to buy a higher yielding asset.
So, a Bond held to maturity should be reasonably safe, providing the Issuer pays it back. However, there is a glitch - Bond Unit Trusts.
Most people get their exposure to Bonds through Bond Unit Trusts. The problem here arises from Redemptions - if many people want to take their money out of the Unit Trust, then the Fund Manager may be forced to sell Bonds at prices below the Issue / Maturity value - this could negatively impact the Unit Trust performance. Additionally, in a time of crisis, you may want to get your money out of the Unit Trust but it often happens in such panics that the Fund Managers close the fund to Redemptions - i.e. you cannot get your money out until the crisis has passed.
If I am right (I may not be, but why take the risk?) then once the 30 year Bond Bubble bursts there could be a big scramble for the Exits from Retail Investors who panic - this would mean mass redemptions from Unit Trusts and could be very nasty. It is hard to envisage Bond Yields falling much lower from these utterly unprecedented low levels - so it is extremely unlikely that Bond Prices can rise much further.
Quantitative Easing (QE - sneaky name to disguise money printing) is probably a factor keeping Bond Yields low - Central Banks buying Bonds keeps their Prices artificially high - this is coming to an end in US and UK and it is debatable whether QE will ever be done by the ECB in the Eurozone. Japan is undertaking a massive QE programme however, but this is primarily aimed at Japanese Domestic Bonds.
Another key consideration here is to understand the Purpose of Bonds in your portfolio. Conventional thinking seems to be that Bonds provide ‘safety’ while the Equity (Stocks/Shares - just words for same thing really) Component is what really drives your returns over the Long Term. I agree with this from a logical standpoint, however, at present, because of the reasons outlined above, I think they will not give you any Safety in your Portfolio and could, conversely, actually bring a huge amount of Risk into your Portfolio - this is much misunderstood in my view.
I think there might be a another reason to question the role of bonds in your Portfolio - that of correlation. Theoretically, in times of Stockmarket distress like we have suffered in recent weeks, your Stocks will get butchered but the Bond element of your Portfolio is supposed to go up and offset some of these losses - or at least retain its value. Obviously if you take a long term view and hold individual Bonds and hold them to Maturity, then they will hold their value - and in your Portfolio you can measure them on a Daily, Weekly, Monthly basis etc. using static Capital Values (the money you put into the bonds).
This could be seen as a bit of a fudge though as these are Traded Financial Instruments and their value varies day to day - but if you hold to Maturity this is irrelevant and ‘Marking’ your Bonds to their Market Value is probably nonsensical. Obviously we are making big assumptions about the Bonds being repaid but if you stick to high quality, Investment Grade, bonds in Blue Chip companies or similar low risk bonds, you should have no problems with payback.
The reason I raise the issue of Correlation is anecdotal - I have been working with a friend for several years on building a diversified portfolio of low to medium risk funds and this includes a few Bond Funds - but not much exposure overall due to our concerns. The thing that hit me in the last few weeks is that when her Equity Funds seemed to be falling, the Bond Funds were falling as well - maybe this is another Risk in using Bond Funds (Unit Trusts in this case) - their Correlation benefits appear questionable from this experience, albeit short term and unscientific.
To my mind, the bottom line is this. If you want Safety, hold Cash.
In summary, I think Bonds are VERY HIGH RISK at the moment - unless you buy individual bonds and hold to maturity - but that is a very specialist undertaking and I would not do it myself.
By the way, I think low bond yields are still a very supportive factor for Stockmarkets - the dividend yield on stocks thrashes Bond Yields and many people are effectively forced to buy stocks (the jargon is Financial Repression - where the authorities have encouraged people into Stocks to keep government borrowing costs low and create bullish stock markets which is believed to have a positive ‘wealth effect’ for the wider economy).
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