Should You Be Investing In Bonds?

Bonds are an essential part of most investment portfolios for growing wealth and generating income.   In simple terms, a bond is a debt security where the investor lends money to an entity, which could be either a business or the state government or local municipality.                

The party receiving the money is known as an “Issuer” and the other party lending the money to the entity is known as the bond holder.  It similar to an I.O.U, with a difference that the Issuer promises to pay the bond holder a specified rate of interest during the life of the bond and also repay the face value of the bond, this is known as the principal when the bond matures or expires.  Note that bonds are also known as gilts, investments in UK public debt and Treasury securities, investment in US government debts. Bonds are traded on the financial market. 

Prudent investors follow the golden rule of investing, which is not to put all their eggs in one basket. In investment terms this means maintaining a diverse investment portfolio, balancing the risk-the potential of high growth with a stable income. The main advantage of bonds as an investment class is that the issuer pays the bond holder an annual income in the form of interest payments on the bond.  Usually, bonds pay out interest twice a year; hence the investor has some kind of predictability of income from their investments.

Investors approaching the retirement age prefer investing in assets generating a stable income, over alternative instruments that have a higher potential of growth but equally a greater exposure to risking their capital.  Bonds feature predominantly in investment portfolios where the objectives are to preserve capital, but also generate a stable income.  If you are approaching retirement and have an investment portfolio, perhaps you may wish to check with your financial adviser what percentage of your portfolio investments contains bonds.

However, keep in mind the general rule of thumb that all investments contain some risks and that there is a positive relationship between risk to capital and returns is equally valid to investing in bonds. Generally speaking the higher the return the greater the risk and vice versa. While bonds are relatively less risky than other assets classes there are a number of factors which can compromise the relative low risk ability of bond investments. For example, the price of the bond is based on such things as the creditworthiness of the issuer, credit ratings, supply and demand and liquidity of the issuer. The maturity date, a specified future date when the investor’s principal is paid, can also influence the bond price. When bonds are newly issued they normal trade at close to their par value, which is their face or principal value.   But as the bonds approach their maturity date their market price is more susceptible to macro-economic influences such as the state of the economy, interest rates and the level of employment. These factors cause the bond price to vary on the secondary market.  A bond is trading at a premium when its price is above its face value and alternatively when the bond is trading below face value it is said to be trading at a discount.As the name suggests a bond’s yield is the return on the bond, based on the price paid, known as the yield to maturity, and interest received also known as the current yield. Bond yields rise when prices fall and visa versa. In other words, there is an inverse relationship between bond prices and interest rates. 

 During the financial meltdown of 2008, in an attempt to choke off a depression, US Federal Reserve and the bank of England implemented an expansionary monetary policy. This is supply side economic thinking favored by centre, centre right governments. The idea is to stimulate the economy, or in the case that preceded the financial collapse of 2008 crank start the economy back to life by lowering interest rates.  The lower, interest rates, it is believed, would stimulate business investment, thereby reducing unemployment.  Whether the policy worked and has prevented another coming Depression is debatable. Critics of the government policy, known as Quantitative easing (QE) argue that QE may have created another bubble in asset prices.  Has this cheap money resulted in sky-high property prices in London, an equity market up 30 percent and a new bond bubble? QE involved pumping liquidity into the system by making cheap money available through the purchase of bonds, which caused bond prices to rise and the desired effect of lower interest rates.

But what has happen to these supposedly safe assets, bonds, are they a safe haven for investors today? During the peak of the 2008 financial crisis investors poured into bonds, away from equities and more risky instruments. They happily rode the wave that the then Federal Reserve Chairman Ben Bernanke had intentionally created in his attempt to lower interest rates by buying bonds, which pushed bond prices up.   However, since then investors have pulled a whopping record 77.5 billion USD from bond funds in 2013, according to research firm Trimtabs. Last year, 2013 went down as the worse year bond funds have ever seen. Chris Gunster, head of fixed income portfolio management for U.S. Trust is forecasting a difficult year for bonds in 2014, nevertheless, he doesn't think it is going to be catastrophic. In his explanation he uses the analogy of a helium inflated balloon resting on a ceiling. "Bubbles tend to burst, balloons just tend to glide down," he said.

But a “glide down,” scenario may be too optimistic. The recent announcement by Barclays bank to cut 19,000 jobs over three years, with the investment side to be most hit by the slowdown in the demand for government and company debts underscores just how bearish the bond market could turn in 2014. So even a relatively low risk investment, which appears to be a safe haven place to hide could still be detrimental to your wealth if you have bought into a bubble. The timing of your entry and exit are still also key.