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.
■ Downside risk protection.
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:
■ Managing interest rate risk.
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.
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.