Bonds are normally issued at par, redeemed at par, and along the way they fluctuate in value as prevailing interest rates change. Their total performance closely tracks inflation expectations. So real growth--if any--is too small to be meaningful. Investors often view them as safe, but the volatility of long-term bonds may be as high as that of stocks, while their return per unit of risk is anemic in comparison. To include insult to injury, long-term bonds have a higher correlation to other financial assets, and they perform abysmally during periods of high inflation.
All in all, the characteristics of bonds as an advantage class are so dismal that you could wonder why any investor will need them at all. Needless to say, not absolutely all investors have similar needs. Many institutions tend to be more thinking about matching future liabilities with assets than maximizing total return. For example, life insurance companies can estimate their future liabilities with some precision. Having bonds that mature on schedule allows them to fit assets with expected requirements. Statutory regulations require them to carry bonds to back up their obligations. To oversimplify, insurance companies mark up the expense of providing benefits to compute their premiums. Total return isn't as important because the spread. premium bonds UK invest
That's not the situation we face as individual investors, though. We should maximize our return per unit of risk, and bonds don't fit in very well. When we plot the risk/reward points for a number of well-known long-term bond indexes from 1978 to 1997, we note that they all fall far below the standard risk-reward line. Not a pretty sight, can it be?
On the 20-year period, various classes of bonds all land well below the risk-reward line between T-bills and the S&P 500 index.
Bonds have only two useful roles to play in our asset allocation plans: They could reduce risk to tolerable levels in a portfolio, and they are able to supply a repository of value to fund future expected cash-flow needs. Needless to say, we don't expect the bond percentage of the portfolio to become a dead drag on its overall performance. It's wise to take prudent steps to boost returns in every percentage of the portfolio. Let's take a peek at some of the common methods employed by fixed-income investors to see if any might advance that goal.
Junk Bonds
Investors accept more risk once they purchase lower-quality bonds. While they are able to increase total return while they move from government bonds to corporate to high-yield (junk), investors simply don't get paid enough to justify the risk. They remain hopelessly mired below the risk-reward line.
Active Trading
All of us understand that the capital value of a relationship whipsaws as interest rates in the economy change. So, if we had an accurate interest-rate forecast, we're able to develop a trading strategy to reap capital gains. Buying long-term bonds before interest-rate declines will produce gratifying profits. Pretty simple, huh? The trouble is, accurate interest-rate forecasts are elusive. Seventy percent of professional economists routinely fail to predict the correct direction of rate movements, aside from their magnitude.
Individual bond selection is suffering from exactly the same problems as equity selection. The marketplace is efficient, and finding enough mispriced bonds to really make the effort worthwhile is problematic. It shouldn't surprise us that traditional active management of bond portfolios fails just as profoundly as does active equity management.
Riding Down the Yield Curve
Borrowers generally demand additional return for holding longer-maturity bonds. The relationship between maturity and return is expressed because the yield curve. When longer-maturity bonds have higher yields, which will be all of the time, the yield curve is reported to be positive. As you will see in the graph below, yield typically rises very gradually, while risk will be taking off sharply beyond a one-year maturity. On a risk/reward basis, bonds with maturities in excess of five years are often not attractive at all. Hence, investors are well advised to confine themselves to the short end of the spectrum.
As a bond's maturity increases, the slope of the danger line is significantly steeper than the slope of the return line.
However, a simple passive technique that I call "riding down the yield curve" can improve yields at the short end of the curve. If the yield curve is positive, simply purchase bonds at an optimum point where interest rates are high, hold them until an optimum point to market at a diminished rate. This captures both the yield on the bond although it is held, and a capital gain on the difference in price. Through the few occasions when the yield curve is not positive, simply hold short-term bonds. Nothing is lost as the rates are higher here anyway. While the procedure involves trading, it generally does not require any type of forecast to be effective. The yield curve is just examined daily to find out optimum buying and selling points. To be effective on an after-trading-costs basis, only the most liquid bonds (U.S. Treasury and high-quality corporate bonds) may be used. Over time, a relationship portfolio having an average duration of only couple of years could be enhanced by 1.25% by using this technique.
Foreign Bonds
The theory is that, at the very least, the biggest basis for yield differences between foreign and domestic bonds is currency risk. If you're to fully hedge currency risk, you need to theoretically be straight back at the T-bill rate. In true to life, opportunities exist to purchase short-term foreign-government bonds, hedge away the currency risk, and still have a greater yield. Benefiting from these "targets of opportunity" can further enhance a short-term bond portfolio, perhaps by a percentage point or two. Needless to say, if you can find no such opportunities during a particular period, just buy domestic bonds.
