While many of the investors who have sold equities in favour of bonds during the bear market are likely to switch back when it abates, credit can offer strong long-term returns in comparison to equities
Corporate bonds have been the only silver lining in a distinctly cloudy past three years for investors.
The turmoil of equity markets has seen investors rushing towards so-called safe haven investments, namely corporate bonds and gilts and it is easy to understand why. Fixed interest has traditionally been a very attractive area for the more risk-averse investor and for those preferring steady income rather than inconsistent growth.
And now these investors are being joined by an increasing number of shell-shocked equity investors who have grown tired of market movements eating up their capital and are looking to repair their battered portfolios.
But those who think of fixed interest investments as simply a strategy for risk-averse investors should consider what else they have to offer in the longer term. Corporate bonds in particular can generate good growth as well as income for investors who seek safety first, but also wouldn't mind getting respectable returns on their money.
While the profile of corporate bonds has never been higher, it is likely that, once this bear market comes to an end, investors who have sold equities in favour of bonds will be eager to make the switch back. However, by making constant progress ' instead of suffering the peaks and troughs of the stock market ' bonds can offer investors very healthy returns that, compare favourably with equities over long periods.
Perhaps deservedly, corporate bonds have a staid investment image. Some advisers only ever think of bonds when dealing with their older clients. The logic behind this is not difficult to follow. More than 25% of the UK population is aged 50 or over, and the Government expects this figure to rise to around 35% within the next 20 years.
An ageing population inexorably leads to a greater demand for fixed-income type investments. However, this doesn't mean bonds should be seen simply as a product simply for the older generation. Advisers who adopt this narrow outlook are missing out on the opportunities to be had through investing in bonds as a diversifying asset class.
In a low-inflation environment, bonds provide steady (if unspectacular) returns. But if there is something that equity markets over the past couple of years should have taught us, it is that boring is not always a bad thing. It all depends on your attitude to risk. It was all too easy for people to ignore risk warnings during the technology boom of the late-nineties.
However, the bursting of the technology bubble has served as a painful reminder that investments can go down as well as up.
It is practically a truism that equities outperform bonds in the long run. Certainly, the upside potential of investing in equities can be significantly greater than for fixed interest investments.
This potential is not necessarily going to turn itself into returns however. In the long run, equities may be a better bet than bonds ' but the truth is that no one knows how long the long run actually is. Five years? A decade? Twenty-five years?
During 2002, corporate bonds managed to outperform the UK All Companies sector significantly. On a total return basis, the equity market fell 22.32%, while the bond market went up 10.19% (UBS Warburg Allstock ex Spec Grade). The story is similar over three and five-year periods.
How do bonds fare against equities in the longer term? Surprisingly well. If you compare total returns of the FTSE All-Share with the corporate bond market (Barclays Non-Gilt Index) over the past 12 years (that is as far back as Sterling corporate bond indices go), you will see that the equity market annualised a return of 8.88%.
The Non Gilt index managed a return of 10.98%. The numbers are even more impressive if you look at BBB rated bonds, where the annualised return over the past 12 years is 14.71%.
So although equities may well offer better returns than bonds in the long term, you could be in the equity market for over a decade and still find yourself missing out in comparison to the healthy returns generated by bonds.
Bonds may make slow progress, but they run a steady course and avoid the market changes that cause equities to run into trouble. Investment grade corporate bonds may not exactly set investors' pulses racing, but they certainly will not be responsible for causing high blood pressure either.
So with no one able to predict with any degree of certainty when equities will live up to their reputation and overtake bonds, the smart money should favour diversification. As any gambler worth their salt will be able to tell you, hedging your bets is a good way to reduce volatility and protect capital.
Diversifying into bonds as well as equities means that you'll never get the massive returns as experienced in equity markets during the mid-1990s. However, a mixed portfolio should certainly help you cover all the angles during the leaner times.
The swings in capital value of a bond fund should be a lot less than in an equity fund. But even when looking at a simple asset class such as gilts you still need to be aware of how the fund invests. It is important to consider the differences between bond funds; these can allow for a variety of investment strategies to suit different types of investor. For instance, if your aim is to minimise capital volatility you should look for a fund that invests in bonds of shorter maturities. If you are looking for total return, you would be better off looking for funds that invest in longer dated issues. These offer better returns ' but carry a higher risk to capital.
Within the bond world, there is still room for investors willing to take on some risk in return for better rewards. Investment grade bonds are issued by companies and institutions with very high credit ratings, and are generally very safe investments.
High-yield bonds are issued by less secure organisations, and so the higher risk of default is compensated for with higher interest yields. However, in the event of repayment difficulties, it is the shareholders of a company, rather than the bondholders, get hit hardest. If a company folds you have less chance of recovering an investment made in a company's shares than bonds. Equity paper is the lowest quality paper that a company issues, and offers investors very little in the way of reassurance if a company goes bankrupt.
Again, it all comes down to the risk you are prepared to take in exchange for greater potential rewards. Equity holders stand to get better returns than bondholders if the company does well. However, if the company folds, shareholders will have a lot longer to wait to get their investment back than bondholders.
Investment grade bonds rarely default, but it is important to realise that re-ratings can happen very quickly, and the downgrading of an AA-rated bond into a BB, means that capital value can slide. Bad news such as debt concerns or board restructuring can have a dramatic impact on the rating of a bond.
In a market where the emphasis is on security and steady performance, any sudden change can have a significant impact on a bond's price, and a re-rating can have a damaging effect on the reputation of a bond. The corporate market is littered with fallen angel bonds that have never managed to recover their previous exalted status.
The current financial climate means greater prominence for bonds in the coming years. The low-interest rate environment, a maturing population, and enduring equity uncertainty are all factors that will contribute to this.
However, just because corporate bonds offer less risk than equities, this does not mean they are unsuitable for investors who seek growth. Over the past 12 years, bonds have offered better growth than equities ' a case of the tortoise catching up and surpassing the hare due to solid consistent performance. Corporate bonds should be considered an essential part of any balanced portfolio.
In a low-inflation environment, bonds provide steady if unspectacular returns
The swings in capital value on a bond fund should be a lot less than on an equity fund
Just because corporate bonds offer less risk than equities, this does not mean they are unsuitable for growth-seeking investors
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