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The truth about bonds

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Written by:
28/09/2011
The basics every investor should know about bonds - adapted from No Fear Finance

One of the most useful characteristics of bonds is that they can be set off against specific short-term liabilities with the same duration. This is good, sensible financial practice. Trying to set off a portfolio of bonds against non-specific long-term liabilities is not.

For one thing, because of the way the bond market works it will be impossible ever to match the respective durations. The duration of the liabilities, even if one believes and accepts the assumptions being made, will always be much longer than that of the bonds. This gives rise to pension funds believing that they are subject to something that they call ‘interest rate risk’ (which is actually just the man-made ‘risk’ of trying to match two unmatchable accounting figures), which can in turn result in them tying up a large amount of their remaining available assets in trying to hedge against this.

The other fairly obvious point to make (but not so obvious that it is apparent to pension trustees, consultants or regulators) is that even if you ignore all the other objections, you can only pursue this course of action if your current assets at least match your discounted liabilities. If there is already a deficit then it can never make sense, unless you are banking (gambling?) on some new inflows of capital from somewhere to make good the difference.

Even then, it can only possibly make any sense at all if you believe that holding capital tied up in bonds will preserve its value in real terms; remember, most pension liabilities are linked to inflation.

Again, it is an implicit assumption of most regulators that this must be the case. Yet the facts do not bear this out. If you had bought UK Government bonds in 1973, for example, you would have had to wait until 1985 to recover the real value of your starting capital – 12 years later, and this assumes that you do not pay any tax. Granted, pension funds typically do not pay tax, but other investors do.

Finally, how can there be any guarantee of capital preservation when a mark to market regime itself makes it impossible? If bond yields are pulled upwards, whether by inflation, interest rates or both, then this can only happen by bond prices being driven correspondingly lower. Thus the bonds that you held yesterday will no longer be worth the same today and you must write them down, suffering a loss.

In fact if you look at bond prices over almost any period you will see that within themselves (as against being compared with other asset types such as equities) they are actually pretty volatile, thus making a mockery of the suggestion that they are ‘risk free’.

Is a bond an investment?

If we define an investment as something that we hope will significantly increase the value of our capital in real terms, then a bond can never qualify as an investment. If you are a non-taxpayer then it is possible that bonds may keep pace with inflation, although even this will be dependent upon when you buy and sell. If you are a taxpayer then they can never even do this.

Bear in mind too, that the money you have tied up in bonds is money that could otherwise be deployed in things that do have a chance of increasing the value of your capital. So, you are incurring what we call an opportunity cost. Any time you have bonds in your portfolio it is like driving a car with the hand-brake on.

Bonds are superb for short-term liquidity and liability matching purposes, but the trick is to keep that liquidity reserve or liability matching section of your portfolio as small as possible, since your long-term objective is to make a significant investment return in real terms, and bonds can never do this for you.

This article is adapted from a chapter in the book  No Fear Finance by Guy Fraser-Sampson, published by Kogan Page, RRP: £24.99. Special offer for Your Money Readers. Get 20% off No Fear Finance plus free p&p from now until 1st November. Phone: 01206 25 5678 and quote NOFF20 when you place your order. Or buy online www.amazon.co.uk

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