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The long and short of bonds

Last week, we started our discussion of the main asset classes and their correlation with each other by looking at money on deposit or “cash”.

We continue by moving on to fixed-interest Government securities. These include permanent interestbearing securities (issued by building societies), corporate bonds (issued by companies primarily for the purpose of considering mainstream investment planning, stockmarket-listed companies), local authority bonds (issued, as the name implies, by local authorities) and Government bonds (or gilts as they are commonly termed).

By far the most important of these fixed-interest securities is the Government bond market, so that is where we start.

Government bonds are, technically, loans to the Government issued with a nominal value of £100 – the price at which they will be redeemed at some date in the future, varying from just a few months to more than 30 years (with a few exceptions, known as undated gilts, which we will discuss later), as stipulated in the terms of each issue.

The investor knows if he holds the bond to its redemption he will get £100 and, in the meantime, he will also get a stipulated annual rate of interest known as the coupon.

This coupon varies between different bond issues, with a fairly typical example being the 7.25 per cent 2007 bond. The title means that the bond will be redeemed (at £100) in 2007 and will in the meantime produce a yield of 7.25 per cent of £100 (that is, £7.25 each year for every bond purchased).

This is an example of a medium-dated bond, with “shorts” being those due to be redeemed within the next five years, “mediums” being those with a redemption date five to 15 years and “longs” having a redemption date of over 15 years.

After the bond is issued by the Government to investors, a second market is created within which the bond may be freely bought or sold.

The price at which future transactions take place will depend on the forces of supply and demand which are in the main governed by how attractive investors consider the bond&#39s coupon.

This will in turn, of course, depend on interest rates prevailing at the time in the market generally.

At the time of writing, competitive interest rates indicated that the market considered a fair annual rate of return for this bond to be very close to 5 per cent.

This means that the bond, with a coupon of 7.25 per cent, offers a highly attractive notional yield and so the pressures of demand at its £100 redemption price will be far higher than the willingness of existing holders to sell.

This, of course, pushes up the market price of the bond to a level where its expected annual return matches 5 per cent. As it happens, the market price (mid-February) was £112.80 per bond.

Now, at £112.80 per bond, the effective annual yield is around 6.42 per cent (that is, the annual interest payment of £7.25 expressed as a percentage of the £112.80)and this is known as the running yield.

All well and good but although the investor on a year-by-year basis appears to benefit from a yield of well over 6 per cent, he must remember that, while he has bought the bond at over £112, it will be redeemed in around six years&#39 time at only £100.

He must, therefore, expect to suffer an annualised capital loss. Even if he does not hold the bond to redemption, he must expect that the market price in future months and years will fall towards £100 as the bond draws nearer to the time when we know the holder will lose the bond in return for £100.

With this annualised capital loss taken into account with the annual income, the overall annualised return falls to what is known as the redemption yield 5 per cent – the fair market return we mentioned earlier.

All this core technical stuff is okay but what about the messages for investors or potential investors in these assets? Well, generally speaking, we can summarise by saying that if market interest rates fall, the price of fixed-interest investments should rise as the coupon becomes more attractive.

So if we could predict the future movement of interest rates, we could easily determine whether the value of fixed-interest investments will rise or fall in value over a given period of time. If only it were that simple.

Great care must be taken. First, as the bond nears redemption, its price will fluctuate much less violently.

To give an extreme example, if a bond is due for redemption in one day, it really would not matter to its market price whether prevailing interest rates were only 2 per cent or a massive 50 per cent.

Either way, the interest gained in one day would be exceptionally small and so the market price of the bond would be £100. Only longer-dated bonds, therefore, potentially fluctuate wildly as market interest rates change.

The message for portfolio planning? Determine your risk profile in considering whether fixed-inter-est investments might form a valid part of your portfolio and, if so, then determine a suitable remaining redemption term.

For those considering collective investment funds (investment bonds, unit trusts and Oeics, etc), you should investigate the fund manager&#39s stated strategy in this respect or, in the absence of such a statement, consider the redemption yield on the fund&#39s main bond holdings.

Now I want to turn to the aspects of asset holdings in portfolio planning we have laid down for particular consideration in this series of articles past and (expected) future investment returns and past and (expected) future volatility and our first real-life look at the correlation or expected correlation of these returns with those of money on deposit.

The table above should set the scene nicely, relating to returns over the last 20 years. Returns from gilts are income and capital gains (or losses) added together each year.

What do these figures show us? Of course, they show clearly that the average annual return from long-dated gilts – and I must stress again the importance of distinguishing these from the returns from shorter-dated gilts, where the difference is by no means as spectacular – has been much higher than from cash (13.5 per cent against 9.5 per cent).

They also show that gilts have proved much more volatile than cash (one SD of 10 against 4.5).

Here, it is worth revisiting the meaning of 1SD: within what percentage margin, away from the average, have annual returns yielded in 70 per cent of all years under consideration.

Thus, we can see that gilts have deviated further away from the average (10 away from 13 per cent) than has been the case with cash (only 4.25 away from 9.5 per cent).

These figures are brought into focus even more when we look at the figures for 2SDs although the gilt figure is somewhat distorted by one exceptional year – 1982 – when long-term interest rates fell heavily, creating a massive capital gain for fixed-interest securities.

Next week, we will expand this comparison between cash and gilts before widening our thoughts to other fixed-interest investments and then to index-linked gilts.

In the meantime, do you have any initial thoughts on how the returns from gilts and from cash might have proved correlated or otherwise in past years?

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