Bonds in 2021

Most investors will be aware of the 60/40 model for cautious investors seeking growth in the markets whilst avoiding the turbulence of a pure equity portfolio. In this model, the portfolio is comprised of 60% equities and 40% bonds. Historically, bonds have much lower volatility than equities, causing the overall value of the portfolio to drop less during market downturns and soothing the nerves of investors who have a low risk appetite. Personally, I view bonds as more of a cash equivalent – something to provide quick liquidity in the event that I need it whilst still providing a yield. Of course, over the last few years that statement has become less and less true as yields on bonds have fallen (in many cases into negative territory). So are bonds still worth investing in in 2021?

Much like equities, the answer depends on what bonds you invest in. Broadly speaking there are four types of bond;

  • Government Bonds
    1. Gilts/Treasuries/Eurobonds
    2. Inflation Protection Bonds
  • Corporate Bonds
    1. Investment Grade
    2. High Yield/Junk Bonds

Within these, you have a few different structures:

  • Fixed Rate Bonds – a fixed rate of interest (or coupon).
  • Index-linked Bonds – a rate of interest linked to an index (for example the Consumer Price Index, or CPI)
  • Floating Rate Bonds – a variable rate of index linked to a refence rate (for example the Bank of England base rate)
  • Zero Coupon Bonds – a zero coupon bond issued at a discount to redemption value.
  • Convertible Bonds – a bond with a rate of interest and an option to convert the bond into a pre-determined number of shares at a future date.

In addition to the types and structure of bonds, investors also need to be aware of the quality of the bond. Most retail bonds are graded by one of the ratings agencies, with bonds rated BBB or above being considered ‘Investment Grade’ and those rated below (BB, B, CCC, CC, C and D) being considered ‘Junk Grade’. The different ratings agencies have slightly different scales which I’ve set out below;

Aa1AA+AA+High Grade
A1A+A+Upper Medium Grade
Baa1BBB+BBB+Lower Medium Grade
Ba1BB+BB+Non-investment Grade Speculative
B1B+B+Highly Speculative
Caa1CCC+CCCSubstantial Risk
Caa2CCCExtremely Speculative
Caa3CCC-Default imminent with little prospect for recovery
CDDIn default

I’ve written before about the dangers of lumping ‘bonds’ into a single category and assuming that they’re safe. In a nutshell, that table demonstrates why. Many investors will look at the word ‘Bond’ and see it as synonymous with ‘Low Risk’ but this isn’t the case. Investors consider the risk of loss when pricing bonds – to lend to entities with a perceived high risk of default, they will demand greater interest payments to compensate for the risk that they may never receive a return of their initial capital. Likewise, if inflation suddenly spikes, the price of inflation-linked bonds, on which the interest coupon increases as inflation rises, will also increase.

But these issues still fail to negate my original interest in bonds; as a cash equivalent in my portfolio which produce a yield. Unfortunately, that yield is becoming smaller and smaller as Quantitative Easing forces up the price of bonds and drives down their yield. Most government bonds now yield less than inflation and corporate entities are issuing bonds at a rate not seen for decades as they attempt to lock in low interest rates.

The problem with both of these is if I invest in the first, I lose money to inflation, and if I invest in the second, I risk investing in companies that are going to have problems repaying their debts when interest rates rise. As such, I currently have less than 1% of my portfolio in bonds, a situation which is unlikely to change in the near future.

A combination of the 2008 financial crisis, long-tail recovery and COVID-19 have led to central banks printing more money than ever before and at a seemingly exponential rate. Their thinking is that by pumping money into the economy, they can soften what is one of the worst economic shocks in over 100 years, but as they continue to pump money into the economy, the risk of inflation running out of control grows.

This easy money is causing companies, governments and individuals to accumulate more and more debt. The huge prevalence of debt makes it harder for investors to discern good debt from bad debt. When every entity on the planet seems to be swimming in an endless pool of borrowing, how can you tell which ones are wearing trunks until the pool is drained?

This is my concern. Since 2008, the BBB tranche of global debt has ballooned. Currently marked as ‘investment grade’, I wonder what will happen when interest rates rise and those bonds get downgraded to CCC or worse? Trackers and pension funds will be forced to sell them, forcing their prices down further and causing a huge tidal wave of junk debt which regular retail investors have little appetite for.

These BBB bonds are currently owned by those hundreds of bond funds I mentioned earlier in this article, which in turn are owned by thousands of unsuspecting retail investors. If those BBB bonds are downgraded, those funds will be force into selling the bonds of at a discount, destroying shareholder value. If instead they decide to try and hold onto the bonds to prevent being forced to book the loss, they will be in breach of their prospectus terms and liable to investigation by the regulators.

Taking this into consideration, I don’t foresee a sudden appetite for more bonds in my portfolio. I may continue to hold a very small percentage of bonds in 2021 but ultimately, I continue to have little interest in holding bond trackers.

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