High quality bonds in the spotlight

There is an old adage in the investment world that ‘diversification is always having to say you are sorry’, as there is usually one (or more) parts of the portfolio that is a bit disappointing. Every asset class has its day in the spotlight, for good or for bad, at some point.

There is an old adage in the investment world that ‘diversification is always having to say you are sorry’

Over the past couple of years, shorter-dated, high-quality bonds that constitute strong defensive assets have delivered low returns and have had a finger pointed at them, by some. Bond yields have been at historical lows, with yields on 5-year UK government gilts at or below 1% for the past three years. Today they stand at around 0.2% and that is before the impact of inflation. It is understandable that investors find low yields frustrating, but one needs to look at the bigger picture. Bonds sit in long-term portfolios predominantly to provide some stability at times of equity market turmoil.

In the face of these low yields, investors have had two straight choices: accept the fact and stoically maintain the quality of their bonds; or go in search of yield by owning lower credit quality bonds and/or bonds of longer maturity. We know that many have been tempted by the latter strategy. We have stuck to the former to defend the portfolio at times of equity market turmoil such as this. Remember that the lower the credit quality of bonds, the more they act like equities.

We think of yield-driven bond strategies – particularly high yield bonds – as akin to picking up pennies in front of a steamroller, which works nicely until you trip over. The chart below looks at the performance of different types of bonds since the equity markets began to fall in February this year.

It reveals that high-quality bonds have more or less held their value, doing the job asked of them. As one moves down the credit spectrum to lower quality companies, returns become increasingly negative. Owning these lower quality bonds, but with longer maturities, simply magnifies these falls (heading from left to right in the chart). As it has always done, scared money runs from higher risks (including the possibility of default on bonds from less healthy companies) which drives yields up and prices down. It tends to move into high-quality, liquid assets driving bond yields down and prices up.

As Warren Buffet once said: ‘Only when the tide goes out do you discover who’s been swimming naked.’

Fortunately, your portfolio has kept its trunks on!


About the Author

Dom is a qualified and experienced Chartered Financial Planner (CII) and Chartered Wealth Manager CFP (CISI) and a Registered Life Planner (Kinder Institute) with over 30 years experience. His work primarily focuses on retirement income planning, helping clients to maintain financial dignity and independence in retirement. Read more from Dominic...
This article is distributed for educational purposes and should not be considered investment advice or an offer of any product for sale. This article contains the opinions of the author but not necessarily the Firm and does not represent a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.
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