InvestmentsSep 1 2022

What role can different bond types play in a portfolio?

Supported by
Pimco
twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Supported by
Pimco
What role can different bond types play in a portfolio?
Photo: Thirdman via Pexels

Bond issuance is huge, and constant, creating a flow of potential new investments for clients. 

In a 58-page Market Trends report on corporate bonds, published at the end of 2020, the OECD said the global outstanding stock of non-financial corporate bonds reached an all-time high of $13.5trn (£11.37trn) in real terms.

The OECD report said: "This record amount is the result of an unprecedented build-up in corporate bond debt since 2008 and a further $2.1trn (£1.76trn) in borrowing by non-financial companies during 2019, in the wake of a return to more expansionary monetary policies early in the year."

The report stated that its focus wass on a dataset of "more than 92,000 unique corporate bond issues by non-financial companies from 114 countries between 2000 and 2019". 

Bonds should continue to offer investors the benefits of diversification away from equities.Dzmitry Lipski, Interactive Investor

And then there are the billions of pounds worth of government bonds to consider. 

Lexicon

It is worth talking about some of the language used in fixed income, which can be confusing to the ordinary client. For example:

  • A bond could be called a coupon, an issue, corporate debt, company paper, a bill, certificates, credit, sovereign or fixed interest.
  • You can be paid a yield, a coupon, interest, dividend or income. All of these generally mean the same thing but different fund groups might use different terminology, so it is worth clarifying that the consumer knows what their expected return would be.
  • You have to know what a maturity date is and what the duration of a bond is – and these do not necessarily have to be the same as each other.
  • There is the spread, which is effectively a bond’s yield relative to the yield of its benchmark/another bond with a different maturity.

Different types of bonds

There are all sorts of themes and variations, too: sovereign bonds, corporate bonds – investment grade and high-yield – green bonds and others. Government bonds have their own nicknames: UK government bonds are gilts; US Treasury bonds are T-bills.

Within the world of corporate bonds there are categories and sub-categories, such as Co-cos, Tier 1, Panda bonds, Junk bonds – a brief summary of some of these can be found in the info box below. 

They can all have different yields, and the difference between the yield on a government, corporate (investment grade) and high-yield bond is known as the spread. 

At the end of the day, credit has an asymmetric risk-profile.Michael McEachern, Muzinich & Co

A Pimco spokesperson explains: "Typically, the yield on a bond issued by a company would be higher than the yield on a government bond of the same maturity, as governments tend to have better investment ratings than private businesses."

"The riskier the issuing company is perceived to be, the wider its bond yield spread will be relative to government bonds," the spokesperson adds.

This is why an investor might be lured by the potentially higher rate of return promised on a low-credit, high-yield bond despite the higher risk attached.

Because bonds have tended to perform differently to equities, they have been used to provide diversification.

The OECD stated: "In comparison with previous credit cycles, today's stock of outstanding corporate bonds has lower overall rating quality, higher payback requirements, longer maturities and inferior investor protection."

Not for nothing does Michael McEachern, co-head of public markets at Muzinich & Co, comment: "Bond investors must contend with inflation, the potential for recession and global macro uncertainties.

"At the end of the day, credit has an asymmetric risk-profile – that is either a company defaults or it pays par at maturity."

So how do managers find high-quality bonds that offer enough of a cushion against risk but still achieve a decent spread? 

What of the 60:40 rule?

The traditional way for investors to accumulate money within a balanced portfolio has been to have 60 per cent in equities and 40 per cent in bonds.

Over time, as the individual's lifestyle changes – perhaps the investor has retired and wants a higher income payout and a lower exposure to equity market risk – the equity weighting would typically reduce while the bond allocation rises. 

But the recent bond sell off has challenged the concept of a 60:40 portfolio.

In the first six months of this year, the total outstanding value of UK corporate bonds fell by 13.3 per cent to £1.94trn from £2.24trn, a fall of £297.5bn.

This compares with a fall of 3 per cent for the FTSE100 over the same period, while gilts dropped by 14.8 per cent, the biggest drop since the 1980s.

Maybe the grim reaper should hold onto his horses.David Henry, Quilter Cheviot

Collidr's investment director Colin Leggett says the collapse in bond prices has been a major challenge for those who hold bonds for defensive purposes, on the assumption that they will provide downside protection when equities are falling.

According to Leggett, this collapse in bond prices has put “another nail in the coffin” to the traditional, static 60/40 portfolio solution that many fund managers have developed for retail investors.

He says: "The 60:40 strategy is based on the principle that the 40 per cent weighting in bonds will reduce the risks and volatility of the overall portfolio.

"However, bond prices have become so overstretched they have been vulnerable to rising inflation and interest rates."

Not dead yet

But Quilter Cheviot's investment manager David Henry says people should "not be so fast" to say the 60:40 model is dead.

He says: "I have certainly had more emails recently from fund houses landing in my inbox decrying the death of the classic 60:40 equity/bond portfolio than I have in previous years.

"But if we look at the historical numbers, maybe the grim reaper should hold onto his horses."

He explored quarterly returns for stocks (MSCI World, the global stock market) and bonds (gilts, loans to the UK government) since 1986. 

There were nine quarters when the prices of both bonds and stocks fell in tandem. It has only happened once since 1986 in consecutive quarters – Q1 and Q2 2022.

"Breakdowns in diversification, like we have seen this year, are rare. We then looked at 12-month forward returns for a 60/40 asset allocation following quarters where stocks and bonds fell together." 

Overall, he says – citing the table below – returns were pretty healthy following those quarters.

Quarterly period

1Y total return in 60/40 portfolio post quarter

Q1 1990

10.30%

Q2 1994

8.30%

Q3 1999

15.50%

Q2 2006

7.80%

Q2 2008

-4.00%

Q1 2009

25.40%

Q2 2015

14.50%

Source: Quilter Cheviot

For Gavin Haynes, investment consultant and founder of Fairview Investing, a "barbell approach" might make sense. 

"It feels too late to invest in traditional index-linked bonds, which are already pricing in a high inflationary backdrop.

"With such economic uncertainty, having a barbell approach within bond portfolios makes sense.

"This would be between areas such as short-duration high yield, which would be less impacted by ongoing high levels of inflation, and longer-dated higher-quality government bonds to provide insurance against a backdrop of recession, where inflation would be expected to fall back and defaults increase."

Diversification is key

Interactive Investor's head of funds research Dzmitry Lipski comments: “Bonds should continue to offer investors the benefits of diversification away from equities, along with stable income and relatively low volatility, especially in periods of economic uncertainty."

But there are actions an adviser can take to protect the client's portfolios from things such as rising inflation, political or sector risk.

According to Moneybox's Brian Byrnes, head of personal finance, "the best course of action an investor can take in a rising inflation environment is to have a diversified portfolio".

Have some rules in place to rebalance your portfolio.David Henry, Quilter Cheviot

He explains: "While 2022 has been a difficult year for portfolios, some segments have done relatively well, such as energy.

"However, it is very difficult to consistently tell in advance which sectors are going to do well in any particular investing environment."

Henry adds: "The whole point of setting out your investment process in advance is to have some rules in place to rebalance your portfolio when it can feel uncomfortable to do so – history tells us that this is often the right approach to take."