When your word is as good as your bond

Conor White writes that investing in corporate bonds should be safer than investing in equity and that bonds outperform stocks at certain times in the economic cycle — like now, for instance.
Have you ever heard co-workers talking around the water cooler about a ‘hot tip’ on a bond? Probably not. Bonds do not have as exciting a profile as the stock markets, but do not let the image mislead you.

Bonds are important in tough times, as they smooth out the dips from falling equity markets and continue to provide an income. This is essential when equity dividends are being cut across the market, and investors still require investment income in their wealth portfolios.
h4. A safe haven for your money
In general, investing in corporate bonds should be safer than investing in equity. The reason for this is the priority that debt holders have over shareholders. If a company goes bankrupt, debtholders are ahead of shareholders in the line to get paid.
In fact, the creditors (debtholders) usually get at least some of their money back, while shareholders often lose their entire investment.
In terms of safety and credit default risk, bonds from an OECD government (Gilts or Treasury bonds) are considered virtually ‘risk-free’, if held until they mature.
As a result, Government bonds are often used as a safe haven for funds in times of crisis.
h4. Protecting performance in tough markets
It is not unusual for stocks to lose 25 per cent in a year, particularly in recent times. However, when bonds comprise a portion of your portfolio, they can help smooth out the bumps when a recession comes around, and ease the pain of a falling stock market seriously eroding your wealth.
An equity-only portfolio of European shares over the last 10 years would leave you now with a return of -3 per cent.
By including bonds in the portfolio at 50 per cent, the investment return changes to +45 per cent, greatly reducing the damage from falling equity markets.
[The equity component illustrated here is the total return (i.e. including dividends) from the DJ Eurostoxx 50 and the bond element is the Merrill Lynch over five-year Government bond index.] The balanced portfolio rebalances each year to 50 per cent equities: 50 per cent bonds. It is interesting to note that if you do not include dividends in the equity index, the equity performance is even lower, showing a return of –26.7 per cent.
h4. Predictable returns
If history is any indication, stocks will outperform bonds in the long run. However, bonds outperform stocks at certain times in the economic cycle, like now. There is an inverse correlation between interest rates and bond prices, so as interest rates fall to support economies in recession, bond prices tend to go up. This makes sense as the price of a bond is simply the sum of its discounted future cashflows, or put another way, the present value of its future cashflows. Reducing the rate used to discount these cash flows results in a higher price.
One of the advantages of buying bonds and holding them to maturity is that the future cashflows over the life of the bond, including the redemption amount, are known in advance.
Selling the bonds before they mature may well be part of an investor’s strategy, but this adds market risk to the strategy, as bond prices change from day to day. There are always conditions in which we need security and predictability. This is the case more so now than ever. The question frequently asked in these times is how do we lower our financial risk without over sacrificing potential return?
Retirees, for instance, often rely on the predictable income generated by bonds. If your portfolio consisted solely of stocks, it would be quite disappointing to retire this year or even next.
By owning bonds, retirees are able to predict with a greater degree of certainty how much income they will have in their golden years.
College savings are another good example of funds you want to increase through investment, while also protecting them from risk by including some bonds.
More conservative investors whose investment needs may be somewhere between equity exposure and bank deposit rates are another group for whom bond investment may be suitable.
h4. Returns on bonds
What kind of returns can an investor earn from investing in European government bonds?
The Irish ten-year bond is offering 5.67 per cent at the moment, while the German ten-year Government bond which is seen as the safest haven in European bonds, is trading at 3.06 per cent.
One of the reasons for this difference is because the international markets now have more concerns over Ireland’s credit rating and ease in repaying its sovereign debt.
For an investor buying bonds, this could well be an attractive opportunity to take advantage of these concerns and to lock in an attractive yield.
h4. Bond funds
As with equities, investors can also choose to invest in bond funds or bond ETFs (exchange traded funds). Funds and ETFs diversify across many bonds, and can add to the investment return by incorporating longer dated bonds and corporate bonds into the scenario as well.
There are a number of funds and ETFs to choose from, depending on the customers requirements, appetite for risk and target returns.
Perhaps you are looking for a higher rate of return on a portion of your wealth than offered by a deposit account, but not willing to invest in the equity markets just yet.
One investment strategy that can allow you to do this is to include bonds in your investment portfolio. For many, reducing risk and taking advantage of the combination of capital protection and a steady income is vital to surviving these times!
* Conor White is a Senior Portfolio Manager with Goodbody Stockbrokers. He can be contacted on 01 6419295 or conor.p.white@goodbody.ie
* Goodbody Stockbrokers is the stockbroking arm of the AIB Group. Goodbody Stockbrokers is regulated by the Financial Regulator and is a member firm of the Irish Stock Exchange and the London Stock Exchange.
* This publication has been approved by Goodbody Stockbrokers. The information has been taken from sources we believe to be reliable, we do not guarantee their accuracy or completeness and any such information may be incomplete or condensed. All opinions and estimates constitute best judgement at the time of the publication and are subject to change without notice. The information, tools and material presented in this article are provided to you for information purposes only and are not to be used or considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities.