Don’t Go Ditching Your Bonds Just Yet…
By Michael Dow
Bonds have long been described as the ‘meat and potatoes’ of any sensibly composed investment portfolio. When the stock markets and interest rates took a huge dive all those years ago the financial world couldn’t get enough of them. Now the tide has turned, with cash-hungry people taking all kinds of gambles to get a piece of the stock market pie. With interest rates in key Western economies looking set to rise, bond holders are starting to panic about the future valuation of their previously prized asset class.
But could they be making a big strategic mistake? Despite the incredible stock rallies we have seen in the last year or so, many institutional investors still favour corporate bonds over corporate equities, and with good reason. One financier with a very strong appetite for corporate debt is Canadian business tycoon and prolific investor Kevin O’Leary. When asked about his preference for corporate bonds over equities and commodities, he stated that he is, “a big believer that I will get the same returns out of corporate debt, whilst being paid anywhere from 4-7% yield on these bonds, than I will from owning the equities.” He also points out that, “a double B or a triple B bond is serviced before companies pay dividends.” Big companies in today’s world are well aware of the dangers that debt poses to investor confidence. They are more incentivised than ever before to pay off liabilities before even considering big dividend pay outs and expansions or acquisitions. This kind of deleveraging has been happening all over the world for some years now, potentially making the corporate debt environment much healthier than it was prior to the 2008 meltdown.
Then there is the all-important yield factor: the true key to long term riches without reckless risk taking. One of the key ways to make money work for you is to put it into the places where it can create a steady stream of income that will compound over time, and perhaps most importantly, shield you from the evil demon that is inflation. When it comes to fixed rate investments such as bonds or even very basic high interest savings accounts, the truth of the matter is that unless the rate of return on your cash is higher than the rate of inflation you are letting your wealth gradually decay. When it comes to government debt, the typical yield you could expect to get from US Treasuries or UK and European gilts these days is between 1-4% (depending on the duration to maturity and a variety of other factors which influence the rate of return at any given time). In fact, judging by the ECB’s actions in recent years, any valuation surges above this range for short-mid-term bonds will be met with measures to bring yields plummeting back down.
Admittedly, acquiring a strong corporate bond portfolio requires a significant amount of technical expertise. The good news for the average individual investor is that there are some superb, well managed bond funds out there which tend to focus on either specific types of bonds (i.e. low or high risk, long or short term maturity etc.), or aim for a solid spread with a good balance of risk and return in mind. Moreover, with inflation rates expected to stay somewhere between zero and 2% in most European and North American nations, there is a very real chance that in nominal terms, government bond yields will fail to return anything to investors. Corporate bonds, particularly if you can stomach the prospect of putting your money into bonds that are rated below BBB (commonly known as ‘junk bonds’), can easily return 5-10% per year; even more in some cases. The more risk you are willing to take on and the longer you are willing to wait in order to let your yield compound then obviously the better it will be for your overall rate of return.
So that is the nuts and bolts of why bonds, particularly corporate bonds are still worth holding onto. They look ever more attractive though when we compare them to certain other investment opportunities out there today. The stock markets are the obvious danger zones at the moment. The Chinese market has seen booms and busts galore in recent months. This month it came crashing down in dramatic fashion yet again, despite consistent efforts from authorities to put some damage limitation measures in place. Nobody knows where exactly the great Chinese stock explosion will end, let alone when is the right time to put money in or take it back out.
Key indexes in the Western hemisphere aren’t looking too great either right now. The American markets and the FTSE in London have undergone very sizeable corrections. There may well be more turbulence to come later this year, particularly if the expected interest rate rise dampens speculator credit. And of course it is no secret whatsoever that commodities are performing very badly indeed as an asset clash for investors. Whether we are looking at crude oil or industrial metals, it has become blindingly obvious now that the so called ‘commodities super cycle’ is well and truly over.
Basically, as things stand, investors are caught between a rock and a hard place for the most part. Sure bonds of all kinds carry their fair share of risk and the returns on the safer end of the spectrum hardly seem worth the bother. That being said though it certainly isn’t the time to be ruling them out altogether. They are and always will be a fantastic method of balancing out a portfolio.
