Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
Bonds have never been the coolest part of anyone’s portfolio, but at least they’ve always had a role to play. While equities were busy doing the heavy lifting, bonds were there to soften the blows, provide a reasonable income stream that looked assured, and offer a relatively low-risk return. Like the maverick Captain Kirk paired with the level-headed Spock, their differences combined to form the perfect friendship.
But with equities recovering strongly from their April lows, bonds have struggled to keep up. Ultra-low interest rates and quantitative easing programmes have squeezed yields, and their allure as low-risk diversifiers is being tarnished by fragile economies that present a real risk of default. All this leaves bond investors with the unappetising prospect of higher risk offering lower returns.
This raises two questions. First, do bonds still have a role to play in a well-balanced portfolio? Second, are there better alternatives?
The answer to the first is ‘yes, but it’s complicated’. As well as recent months’ difficulties, other uncertainties linger on the horizon.
One is inflation. Inflation expectations are rising as governments continue to throw ever greater stimulus packages at their economies. Inflation would be bad news for bonds since it devalues the fixed interest you earn on your investment. The longer the maturity on your bond (that is, the time you’re due repayment on your initial sum), the more exposed it is to inflation risk.
Inflation would also lead to a hike in interest rates. That would be good for yields, but it would also see prices drop on bonds or bond funds you already hold.
Inflation and interest rates are likely to rise at some point, but we don’t know when. And they are not the only uncertainties to consider. We also don’t know how long governments will continue to spend big, if/when economies will recover, what their recovery would look like, nor whether a market correction is due. Any of these could be good or bad news for bonds.
Precisely because uncertainty still abounds, there remains a case for holding some portion of your portfolio in fixed income. Since bonds generally perform differently from shares and alternatives, diversifying across asset classes cushions the blow in case any one of them underperforms.
Whether that justifies the traditional 60/40 split between equities and bonds is less clear. Then again, rules like this aren’t fixed. Different people have different priorities - to some, that rule never made sense anyway. Now’s as good a time as ever to be flexible with your weightings.
That’s the snapshot view of things. Zooming in, we see how it’s actually very difficult to speak about bonds as a whole. Different bonds react differently to the same pressures. That makes the prospects for some better than others right now.
When we speak of how badly bonds are yielding, we’re often referring to developed sovereign debt - that is, bonds issued by governments of developed economies. Their struggles are due in large part to ultra-loose monetary policy feeding those economies’ vast stimulus packages. These are financed by bonds which governments issue and central banks gobble up, driving their prices up and weighing yields down.
Many emerging markets don’t have this problem. Without moving too far up the risk ladder, Chinese benchmark 10-year government bonds, for instance, are yielding above 3% - a significant gain on the US 10-year benchmark, which is hovering around 1%, and should stay there.
And while corporate debt looks riskier right now than it used to, an economic recovery should bolster companies’ prospects and reduce their risk of default.
All this means that being selective is key. The case for bonds remains, but it’s certainly been challenged. If that sounds too much, it’s useful to know alternatives are out there.
Property is the standard one. The case for property remains what it always has been: sustainable income, a high yield and a store of value in uncertain times. But, like bonds, it’s important to pick and choose. Certain areas of this sector have been hurt more by COVID - the outlook for a secondary retail site is clearly very different now from a state of-the-art logistics warehouse on the edge of a motorway.
Funds offer easy access to property investments. The iShares Global Property Securities Equity Index Fund is a fund of funds, which removes the liquidity concern and has the added benefit of geographical diversification.
Another area to consider is infrastructure. While it’s perhaps not the most obvious income source, the case for infrastructure looks strong now. UK and US governments have laid out grand ambitions to invest in the sector and green energy especially looks to be a major area of growth. The FP Foresight UK Infrastructure fund targets a 5% annual income through UK listed renewable energy and infrastructure investment companies, though this is not guaranteed. The fund is one of Tom Stevenson’s ISA fund picks for 2021.
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds. Foresight UK Infrastructure Income Fund uses financial derivative instruments for investment purposes, which may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations. The fund also uses currency hedging. Currency hedging is used to substantially reduce the risk of losses from unfavourable exchange rate movements on holdings in currencies that differ from the dealing currency. Hedging also has the effect of limiting the potential for currency gains to be made. The Foresight UK Infrastructure Income Fund investment policy means it invests mainly in units in collective investment schemes. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
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