In response to client questions, we recently posted part 1 of this article, which looked at the basics of what is meant when people refer to fixed income investing: the securities, what affects their price and how they differ from shares. In this second part we look at why bonds enjoyed a 30 year bull market that many experts forecast will come to an end but why this giant asset class still has a role to play in a typical Australian investor’s portfolio.

A 30 year bull market coming to an end?

Source: IRESS This chart shows the yield of the U.S. long bond. Remember, the higher the yield, the lower the price, so as the yield has declined over the past 30 years, the price has risen. An extraordinary 30 year bull market.

Anybody who had a mortgage back in the early 1980s will remember it as a time of high inflation that was eventually squashed by very high interest rates. We pointed out last week that one of the major influences on bond pricing is the outlook for inflation: the higher it is, the higher the interest rate you’ll require before buying the bond, meaning the lower the price is that you are willing to pay.

Not long after Paul Volcker was appointed as the Chairman of the U.S. Federal Reserve in 1979 inflation peaked at 13.5% p.a. Bond investors had been in a world of pain for almost 20 years as prices reacted to the mayhem of the oil shocks, but after Volcker pushed U.S. cash rates to a peak of 20% in 1981, inflation was smashed. It dropped to 3.2% by 1983 and so began a 30 year bull market for bonds (see the chart above) as investors became convinced that central banks had discovered the secret to keeping the inflation genie in the bottle.

We’re now seeing a world where sovereign bond yields are at or very close to all-time lows, numbers that on the face of them seem like a crazy annual return to accept in exchange for lending money to a government for ten years: the U.S. 1.82%, Japan 0.22%, Germany 0.35%, and if you want a Swiss bond you have to pay them 0.28% p.a. for the privilege! Not surprisingly, almost every bond fund manager argues yields simply cannot go a whole lot lower, which is another way of saying they expect the bull market will come to an end sooner rather than later.

Can you still make money from fixed income?

In short, yes you can. There are many different kinds of bonds, from government to corporate, and you can be pretty much assured that somewhere in the world there are attractive returns being offered. Proper fixed income investments are exactly that: you know in advance exactly what your return will be if you hold the investment to maturity. And if you stick to very safe investments, like sovereign bonds from a reliable debtor, then you can feel very comfortable you will get your money back together with the promised coupons.

But right now you’d think to yourself: hang on, if I buy a ten year bond from the U.S. I’m getting paid 1.8% p.a., which barely covers inflation. As with any investment, it’s a question of how much return you require and the risk you are prepared to take on to increase that return. There are other bonds offering more like 5-6% p.a. For some lucky investors they are happy just to know their money is safe. The other trick, as always, is being able to find them.

Also, there’s a concept in bond investing called ‘duration’, which measures a bond’s sensitivity to changes in interest rates. You can deliberately target bonds that have lower sensitivity to interest rates, called lower duration, which means they will be less risky. The catch is, like all investments that are less risky, the offset is that they come with a lower return, being a lower interest rate.

Some fund managers are even able to make investments that benefit from rising interest rates, which is referred to as ‘going short duration’ (similar in concept to short selling shares – you sell them at a higher price and make a return by buying them back at a lower price).

Does fixed income have a role to play in an Australian investor’s portfolio?

Definitely! One of the classic arguments in favour of all portfolios having at least some exposure to bonds is that they have a low, sometimes negative, correlation to equities. That is, when equities markets go down, bond markets can go up (see the chart below).

Calendar year returns for Australian equities and bonds

(from 31 December 1989 to 31 December 2011)

As we’ve argued many times, it’s next to impossible to predict on a short-term basis which asset classes will do well from one year to the next, but over the long-term you can confidently point to expected returns from particular asset classes. Having diversification in a portfolio is one of the simplest insurance policies you can get.

Another reason is that bonds pay a regular income stream, which for some investors can be exactly what is needed. The chart below shows the total return of bonds compared to shares over a 15 year period, and also shows how much of that return comes from income versus capital growth.

Components of total return 1997-2012

Finally, a portfolio with a blend of equities and bonds can see a reduction in volatility without severely impacting returns.

Asset class and portfolio investment performance

Source: S&P, UBS, Vanguard

Experts have been calling the end of the bond bull market now for several years and at some point they’ll be right. But given the sheer size of the asset class, the contribution it can make to portfolios and the variety of securities to invest in, it should not be ignored.

The global fixed income market is about two to three times the size of the global equities market, yet the average Self-Managed Super Fund here in Australia holds only about 2% of its portfolio in fixed income. On the simple premise that diversification is one of the most important principles of investing, that’s a dramatic imbalance and it can have a serious effect on a portfolio’s long-term performance.

In response to some client questions, this blog post is a “101” rundown on fixed income investing.

What is meant by ‘fixed income’?

‘Fixed income’ is often used as a very broad catch-all description for an asset class to include pretty much any kind of debt instrument, that is, where one entity borrows money from another. As you can imagine, that makes for a very large market. Some of the more common fixed income securities are:

• Government bonds: these are bonds issued by the different levels of government in different countries. Just like a household, sometimes a government needs to borrow to fund its day to day running expenses. These can include everything from national governments (sovereign bonds) to state and local authorities (municipal bonds).
• Corporate bonds: these are bonds issued by companies, usually big ones. This has become very popular since large companies can often get funding through the bond market more easily and cheaply than through a bank.
• Asset-backed securities: these are when a bunch of loans get combined to form a single big lump of debt, which then gets broken up into tradeable parcels. It can cover a multitude of things like mortgage debt, credit cards, car loans – basically any deal where a person or entity owes someone or something money can be packaged up and sold off in bundles.

Another catch all expression that can be used is the ‘bond market’, which captures the fact that all these different securities can trade on secondary markets. So while one entity lends money to another, ownership of that debt obligation can be transferred to an entirely different entity, and can be traded many times over. Or it can be held to maturity, which is when the debt is due to be repaid.

Bonds compared to shares

The two most important characteristics of a bond is that it represents an obligation to pay someone interest on a loan, referred to as a coupon, and then to pay back the entire amount lent on a specific date – so a bond has finite life. Whether a share pays a dividend depends entirely on the discretion of the company’s board of directors, and is subject to fluctuation in line with how the company has performed; so dividends can go up and down dramatically while interest payments don’t change. And shares last in perpetuity, or for as long as the company lasts.

Corporate bonds can also have different levels of ‘seniority’, so if a company goes into liquidation, some bond holders will be repaid in priority to others. And most importantly, any kind of debt instrument will be repaid in priority to a shareholder, who has equity in a business.

It’s that added level of security that is the critical difference between bonds and shares: a shareholder gives money to a company in return for the chance to participate in how well the business does, so if a company’s profits go skyrocketing the shareholder will hopefully benefit from a rising share price. By contrast, a bond holder will only get the interest rate on the bond – the share price could triple and the bond holder’s return will not change at all.

At that point you might be thinking, why would I want to restrict my returns to just an interest rate? Well, it works the other way as well. So if a company’s shares halve, the bond holder’s returns will still not change. That level of certainty can be very appealing to offset the riskiness of a share portfolio.

What determines a bond’s price?

There are a couple of key determinants for a bond’s price: first is how risky is the issuer of the bond? A high risk borrower will have to entice lenders by paying a higher interest rate, and vice versa. This is where the ratings agencies, like S&P and Moody’s, play an important role.

Second, is the outlook for inflation. Since a bond is basically a promise to pay a string of future cash flows at a fixed level, if it looks like inflation is going up, then the lender will want to be compensated for that by receiving a higher price.

You may have heard the curious sounding expression that ‘bonds rallied sending the yield down’. A simplified explanation of how that works is that a bond will normally have a face value of $100. If it’s going to pay a coupon of 10%, then its price will be $90. If investors decide they really like that bond they will pay a higher value for it, sending the price up to, say, $95 which means the yield will go down to 5%. You simply need to remember that yield and price move in the opposite direction.

Part two…

Next week we’ll look at why bonds have performed so well over the past 30 years and why so many experts are arguing that’s set to change, and what role bonds have to play in a typical Australian investor’s portfolio.