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Rob Burdett: Managing the pitfalls of bonds

Much has recently been written on bonds and bond funds, so it is worth going back to basics on the role bonds play in an investor’s portfolio and if they are worth owning at the moment.

Let us remember what a bond is. You lend Dave the plumber £100 – known as the principle – and he agrees that in a year’s time – the term – he will give you back your £100. In the meantime he will pay you £5 a year – the coupon. This is for the risk that Dave may default and also covers you against inflation. 

If inflation is 2 per cent, the £100 will only buy you £98 of the same goods at the end of the loan. If Dave uses the £100 to buy a swanky new soldering tool so he can earn more and can afford to pay back the principle plus the coupon, in total you receive £105. Everyone is happy – you have made £3 – the real yield – on an inflation-adjusted basis and Dave can earn more money going forward.

If you had left that £100 in a leading high street bank account, the best you could hope to earn is £1.60. With inflation at 2 per cent, you would have lost money in real terms. So, bonds are great, right? Well, not always.

The problem is that because bank rates are so low, a decent yield is rare. Anything offering a certainty of income is scrambled over to the point of sucking any value from the asset class. Bond managers have taken advantage of the broadening of fund structure rules and sophisticated financial instruments to try to protect themselves and their investors from inflation, rising interest rates and the default. Following the recent shake out in the bond market, discussions with our fund managers suggest the likes of Dave are having to be more competitive in compensating for the risk of borrowing money. This has seen real yields become more attractive.  

Then there are currency markets. If you had lent Dave $100 when the exchange rate to sterling was 1.63, you effectively lent him £66.66. Over that year, the US economy grew and the currencies moved accordingly. So you now get £69.93 when you go to change your $100 back, plus a bit extra on your $5 coupon. 

There are many other complex instruments available to bond fund managers but ultimately they are all aiming to do the same thing – make sure you get back your £100 plus your £5 coupon and beat inflation in the process. 

At some point investors are going to start getting more money for a deposit in the bank and with inflation predicted to rise at some point, we tend to prefer other asset classes. A diversified portfolio should have a spread of assets. This is where the binary outcome of bonds can play a role in offering a different return profile –  if you are prepared to ride out the volatility and if you have a manager that can find good payers like Dave. 

 
Rob Burdett is co-head of multi-manager at F&C Investments

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