The last four decades have seen the emergence, growth and eventually the almost total domination of the “cult of the equity”. Prior to this, pension funds had invested mainly in bonds, the view being that fixed income securities were a logical and safe home for the money. All this was to change in the 1950’s, in a move largely credited to the then fund manager of Imperial Tobacco, George Ross Goobey. Ross Goobey, an actuary by profession, reached the conclusion that equities were undervalued and started switching the fund into the then unfashionable stock market.
He was right. Over the coming decades, inflation destroyed the real return from fixed income securities and equities proved the place to be. This view, sometimes known as the “cult of the equity” is now almost a universal panacea with equities widely considered to be the first choice for investment.
But is this the whole story? When an investment approach is almost universally adopted, it’s often time to worry. Certainly, the bear market in the early 2000's eroded the longer-term outperformance of stocks, undermining the theory that bonds are simply an antiquated asset class, suitable for only the most unadventurous or complacent investors. Before we move on to consider the potential risks and rewards of different types of bonds, here are the five reasons why every portfolio should contain bonds:
Security: Government bonds offer the investor unparalleled security. The risk of the UK or other major governments being unable to repay their debts is low and government bonds should be considered superior in credit quality to a bank deposit. High grade multi-national government agencies (such as the World Bank) also offer an extremely safe home for the investor holding bonds to maturity. Of course, not all bonds are issued by governments. Many bonds are issued by companies and other organisations whose ability to service the debt may be less certain. However, even corporate debt can be considered a safer investment than the company’s equity. In the event of bankruptcy, bondholders are ranked above shareholders in their claim on the company’s assets.
Return of capital. Bonds also differ from equities in one other very important aspect. In order to realise your profit (or loss) on an equity, you are wholly dependent on the ability to sell the instrument back to the market. When an investor buys a bond, the redemption date is fixed in advance, reducing the investor’s reliance on the uncertainties of future market sentiment or liquidity.
Income: With an ageing population in most developed countries, income becomes an increasingly valuable aspect for any portfolio. Income available from bonds is generally higher than that available from equities. Also, future income payments are a known quantity, unlike dividends from equities, which may be reduced or withheld entirely in times of low profitability. This makes bonds ideal for investors who wish to secure future income over a defined period of time. With bonds paying annually, semi-annually or sometimes quarterly, a carefully chosen bond portfolio with six or more holding can produce a reliable monthly income. Remember also that most bonds pay their coupons gross, without withholding tax. Investors can take advantage of this by holding qualifying bonds within an ISA, producing a tax free income.
Diversification: A well managed portfolio should contain a variety of different assets classes. Equities, government bonds, index-linked bonds, corporate bonds, property and alternative assets all have their role to play. This simple approach, also known as “not keeping all your eggs in one basket” is one of the most effective strategies for reducing risk in a portfolio. In certain economic scenarios, such as a recession, bonds will generally show an inverse correlation in price movements to equities. Note that in the 200-2003 period, when the FTSE100 declined by nearly half from the millennium highs, longer dated gilts saw prices rise over the same period.
Benefit from falling interest rates: When an investor buys a fixed coupon bond, he or she locks in interest rates for a defined period. Because of this, falling interest rates will cause the market value of the bond to rise. Investors who buy bonds in falling interest rate scenarios will receive the double benefit of a secure income and capital appreciation of their asset.
Speculation: any financial instrument offers the potential to speculate on future price movements, and bonds are no exception. Liquid government bonds are often used by traders speculating on future interest rates while corporate bonds can see sharp price movements from changes in the perceived credit quality of the issuer.
Please note, the content on this section of the website is provided for educational purposes. Examples shown of prices, yields and credit ratings may have changed since the time of publication.
Stockcube Research, March 2010