Fixed IncomeAug 14 2013

Short-term bonds can help balance portfolios

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To understand that, first I will need to explain a bit about my view of the role of bonds in investment portfolios. It is important to point out that I am not taking any sort of short-term view.

Having said that, I do acknowledge the effect the current low yields and interest rates may have on assumptions concerning long-term returns in the sector. However, analysis suggests that the long-term risk/return trade-offs for bonds, compared to equities, has not substantially changed.

Whatever value bonds have, I believe they serve several long-term purposes in investors’ portfolios. Bonds can act as a portfolio anchor and provide:

■ Volatility dampening.

■ Diversification.

■ Downside risk protection.

■ Income.

The first three items can be dramatically illustrated by a simple diagram of the long-term (since 1900) return trend for bonds, against the types of annual swings that result from different mixes of bonds and equities. So, for example, a 100 per cent bond fund gives a long-term return trend of around 5 per cent, with its largest historic downside under 25 per cent, with its largest historic upside approaching 50 per cent. A 100 per cent equity fund, on the other hand, has delivered a long-term average of more than 9 per cent, with a largest historic annual fall of more than 50 per cent and a largest annual gain of more than 150 per cent. Between those extremes lay a range of blends that ascend in a fairly linear path, both in terms of volatility and return.

Along that continuum lies a blend that may suit the risk/return requirements of most investment portfolios. Reducing bond exposure as a result of a short-term view of valuations could mean building a portfolio that does not match a client’s risk/return profile or falling into the classic trap of return chasing in alternative asset classes to replace bonds. Both of these options spell potential trouble given that if the bet does not work out, clients will tend to blame the adviser who made the recommendation.

There are three key factors that short-term bond funds could address in client portfolios. These are:

■ Diversification.

■ Managing interest rate risk.

■ Income.

Diversification

Allocating short-term investment-grade bonds can help diversify an overall portfolio or bond allocation. This can prove especially valuable during periods of market stress. Our analysis suggests that a broadly diversified short-term investment-grade bond fund serves this purpose better than a pure corporate bond fund.

Figure 2 shows that during the past 10 years, pure corporate and broader non-gilt investment-grade bond indices have behaved very similarly under ‘normal’ market conditions, but a more diversified index that includes government-related and securitised investment-grade bonds has been a good way of further dampening volatility and downside risk.

Allocating short-term investment-grade bonds can help diversify an overall portfolio or bond allocation.

Interest rate

The sensitivity of a bond portfolio (or allocation) to changes in interest rates is largely determined by its average duration. Thus, one way to manage interest rate risk is by shortening the overall duration of a given portfolio, which can be done by increasing the allocation to short-term bonds.

Income

Short-term investment-quality bonds or bond funds can also be a useful tool for building portfolios designed to pay an income for clients already in retirement.

Charges

Another important point is minimising cost. Investors cannot control or predict markets, but they can control what they pay to invest. Every pound paid in charges decreases an investment’s potential return. Historically, low yields bring this fact into sharp focus.

The slim margins in bond market performance make it hard for active managers to add value, especially when charges are taken into account. Research bears this out. It has been found that, within the broad sterling diversified bond market, 91 per cent of active bond funds either underperformed their benchmarks or were closed during the five-year period to 31 December 2012. The number jumps to 100 per cent at 10 years and 94 per cent at 15 years. I believe that in large part this is due to charges. Active bond managers need to pay for the expertise and research required, which is usually reflected in their annual charges.

Many people are asking, why now for short-term bonds? But to me, this is the wrong question. A short-term investment-grade bond fund is just a logical expansion of the range of low-cost index bond funds available in the UK. I believe that the ‘right’ question is: what role does a short-term investment-grade bond fund serve in a client’s long-term investment portfolio? The answers are: diversification, managing duration and thus interest rate risk, and the potential for immediate income from short-term, high-quality bonds.

Nick Blake is head of retail at Vanguard Asset Management

Key points

■ Analysis suggests that the long-term risk/return trade-offs for bonds, compared to equities, has not substantially changed.

■ A 100 per cent equity fund, on the other hand, has delivered a long-term average of more than 9 per cent.

■ The slim margins in bond market performance make it hard for active managers to add value, especially when charges are taken into account.