5th October 2022 - Tracey Payne

Thinking sensibly about bonds

If we had been given £10 for every article or commentary that we have recently read suggesting that a 60/40 balanced portfolio[1], or bonds as a whole, are ‘dead’, we would be most pleased! So why all the doom and gloom? 

Well, the world feels unsettled. Inflation is high, the Pound is falling in value and both equities and ‘safe’ bonds are down.  That makes investors feel uncomfortable. Yet this short-term negative sentiment belies some relatively positive news that has not been reported on:

[1]    60% in equities and 40% in bonds.

[2]    Examples for educational purposes only include Vanguard LifeStrategy 60 Equity Fund in GBP or Dimensional World Allocation 60/40 Fund (not recommendations).

Sensible reasons for owning bonds

Investors’ portfolio structures are put under the spotlight in times of market downturns. In 2022 it has certainly been bonds in the beam.  It can help to go back to the first principles and ask why an investor owns them in the first place.  The reasons are simple:

Bond yields and future liabilities

Like pension funds and other institutional investors, private investors have their balance sheet of assets (investable portfolio, family home etc.) Along with liabilities (future cash flows they need or wish to meet).  Unfortunately, the financial media only ever seems to report on the asset side of the balance sheet.  ‘Bonds are down!’. Yet that entirely misses the point. Bond prices fall because yields rise, and yield rises mean that liabilities fall[1]

Let’s look at a very simple example, ignoring inflation and taxes to illustrate this.  Imagine that you want to make a gift in 20 years’ time to someone of £10,000.  You place that money in a deposit account to make sure it is there when the time comes. When yields were 0% you would have needed to hold a deposit of £10,000 to meet this liability.  However, with yields at 3% you would only need to place a deposit of £5,537, as the 3% interest would compound up over time to reach £10,000. Each cash flow in an investor’s financial plan is a similar liability that needs funding. Despite asset values falling, the ratio of assets to liabilities has recently improved significantly for many investors. That certainly is a good thing. 

The quote attributed to Mark Twain that ‘The reports of my death are greatly exaggerated’ could just as well be referring to bonds.

[1]     A pension fund or individual investor’s liabilities are usually calculated as a present value. This is done by taking all of the liabilities and discounting them back to today’s value using a discount rate. This may be a government or corporate bond yield. When discount rates rise the present value of the cashflows decrease.

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Risk warnings

This article is distributed for educational purposes. It should not be considered investment advice or an offer of any security for sale. It does not represent a recommendation of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable but is not guaranteed. 

Past performance is not indicative of future results and no representation is made that the stated results will be replicated.

Errors and omissions excepted.

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