Bonds are some of the most versatile investments available in the free market. However, bonds and fixed interest investments in general, are often regarded as the boring low risk, low return investment choice. In most cases, this would be correct. Bonds are typically most attractive to people who have already acquired a sizable amount of capital, and are primarily interested in protecting their savings against inflation, and/or providing a steady annual income. As goes the old adage “Gentlemen buy bonds”.
Bonds are also a key component in any traditionally structured balanced portfolio. As fixed-income investments are typically are negatively correlated to stocks, it is useful to maintain sufficient fixed interest holdings to, in a way, prop-up the rest of your portfolio during down cycles in the market. However, this negative correlation to the stock market is not set in stone; it is more of an after-effect of capital flows out of stocks (when investors flee from, and sell out of stocks, the money has to go somewhere, right?) and, primarily, the negative correlation that bonds have with interest rates. Interest rates are the real focus here.
Traditional bonds are very much affected by movements in interest rates. And these movements are opposite of one another; when interest rates go down, bond values go up, and vice versa.
Let’s take a look at an example…
Say a bond that pays an investor $100 per year is worth $1,000; as the market interest rate is 10%. Jump forward a couple years, and let’s say the interest rate is now only 5%. With the new bonds only paying $50 per year in interest, an investor would have to buy 2 of the new $1,000 bonds in order to received $100 in interest payments each year (2 times $50). Or, the first investor could sell his big $100-paying bond in the current market for $2,000 (as new investors would have to buy 2 new bonds to get the same annual interest payments as 1 old bond).
This is an example of a falling interest rate environment. A rising interest rate environment would instead see the “old bond” losing its value.
This is of course a very simplified example that does not take into account a host of other factors that affect a bond’s valuation (e.g duration, credit or sovereign risk).
US 10 Year Treasury Bond Nominal Interest Rates (Source: US Treasury)
The last 25 years have witnessed steadily decreasing interest rates, and so traditional fixed interest funds that maintain portfolios of bonds most sensitive to interest rate changes have been the most successful.
However, many believe the landscape is changing, and we may begin to see a reversal of this downward trend in interest rates. Likewise, traditional bond portfolios could see a reversal of fortune in their performance and investors will once again look to proven fixed-interest champion investment managers like Pimco for managed portfolios of fixed interest investments.
This should not however be reason to eliminate fixed income from an investment portfolio altogether. As mentioned, the above example is a simplified illustration of the fixed interest market, and investors still interested in regular income are able to insulate themselves from the risks of interest rate increases. For example, more strategic income fund managers are able to reduce their portfolio’s exposure to bonds sensitive to interest rate changes (eg. reducing exposure to “high duration” municipal bonds). Likewise, increasing interest rates are typically a sign of improving economic conditions, at which time the strategic income fund manager could increase his allocation to higher-yielding opportunities in credit-sensitive bonds.