The Risks of Bonds in Your Investment Portfolio - dummies

By David Stevenson

Macro-economic strategies for UK investors are ones in which investment approaches in shares, bonds, commodities and foreign exchanges (FX) are determined by key macro-economic signals.

Here, take a closer look at bonds (which, as tools used by central banks to direct their economies, react fairly predictably to macro-economic trends). Bonds are fairly simple to understand:

  • Bonds are essentially an IOU by an issuer (a government or large corporation) who borrows money from you.

  • The IOU consists of a promise to repay you the principal at some point in the future (at maturity, when the bond is redeemed) and along the way you also receive a regular income called a coupon.

  • This coupon gives you a yield (the coupon interest rate against the asking price for the bond), which you can then compare to the yields from other bonds.

Bond investors are relatively simple folk. They care enormously about capital preservation (getting their money back) and aren’t hugely worried about making an enormous capital gain (unlike equity investors who tend to be very focused on capital gains). They want the certainty of getting repaid in the future and being rewarded with a decent, sensible income along the way that’s sufficient to cover the risks of lending.

The global bond markets are truly massive, with trading levels and deal sizes that tower above equity markets. Many hedge funds prefer to trade in bonds precisely because of this huge scale and depth as well as the relatively lower levels of risk. But investing in bonds isn’t risk-free:

  • Inflation is bad news for bond investors (although bonds that pay a yield linked to inflation indices do offer much more protection). For the most part your interest coupon is fixed to maturity, and so any increase in inflation rates means that you’re getting less real income (that is, after the impact of inflation). Most bonds perform terribly in a high-inflation environment.

  • Credit risk is a large concern for investors.

More precisely, bond investors worry about the following issues:

  • Will the bond holder get repaid: that is, what’s the default risk at maturity?

  • How does the coupon yield compare to other rates from other issuers: that is, are bond investors being adequately rewarded for taking on the risk of default?

  • Is the yield comfortably above current inflation rates?

  • How senior is their specific claim if the worst happens and the issuer defaults: that is, what security exists for one bond against any assets?

  • Do they pay the original issue price (at par, as it’s called), a premium or is the bond priced below its issue price (which tends to indicate that some concern exists that investors may not be repaid in full)?

Bonds don’t always trade at the issue (par) price. Worries about the different levels of risk that comes with different issuers can massively affect prices. If you think a default is even remotely possible, you bid down the price to below par. If you think that the risk level is low and the income yield wonderfully high, you bid up the price above par.

Bond investors worry terrifically about balance-sheet risk, meaning that they minutely inspect an issuer’s assets and liabilities and the accompanying cash flows. They look for any indication of insufficient cash income to pay the regular income coupons. They also worry that balance-sheet stress indicates future credit risk.

All these worries often push bond investors towards a determined diversification strategy. They consciously make sure that they have a mix of different risk levels, yields and issuers. As worries about macro levels of risk increase, they may for instance sell any bonds regarded as a tad risky (corporate bonds, emerging-market bonds) and focus instead on government securities.

Equally, if a sudden financial shock looks imminent, many bond investors switch into short-duration government securities as an alternative to holding cash in the banking system; that is, they run their cash operations by investing in gilts that mature in the next few months.

By contrast, if worries about systemic financial meltdown start to fade away, bond investors look to diversify by investing in riskier assets such as corporate bonds or even bonds issued by emerging-market governments and large corporations.