Bond is Back

Dr John looks at the spicier side of the bond market

Today we consider the spicier side of the bond market, where the risk is higher, but so is the possibility of higher return.

There are two major macroeconomic risk factors with government bonds: interest rate risk (if interest rates rise, bonds fall in value) and duration risk (if interest rates stay high, then longer dated bonds will fall in value by more than shorter duration ones). 

These aren’t so important here in the riskier waters. Think of lending money to your friends. You’re no so worried about interest rates or the global macroeconomic environment, as much as if they will actually pay you back at all.

If you had 20 friends and lent them £5 each, and 19 paid you back, you’d think yourself a pretty good judge of character. Even if two didn’t pay up, you wouldn’t be so worried.

In the bond world this might rank as a disaster. Let’s see how this is the case.

Imagine holding 20 bonds each worth £5 each yielding 10%. That’s a portfolio worth £100. After one year, all being well you would have made £10 and you’re feeling pretty smug.

But these are risky bonds and one of the 20 bond issuers goes bust, just after you bought it. Like a bad friend, they just walk away from their debt.

After a year you have 19 bonds worth £95 and have received £9.50 worth of income (the bond that went also gives you no income). Your bond portfolio is worth £104.50 (£95 plus £9.50). You only made £4.50 profit after a year. 

That’s a 4.5% return, well below the 10% you were expecting. It was all looking so good before that default of just one bond.

If two bonds default, you’re looking at no return.

The disappointment is as a result of the dreaded default risk.

If you’re going to invest at this end of the market, you’d better be choosing a good manager, who can minimise the chance of a bond issuer defaulting, or get a healthy risk premium (high interest rate) to compensate for the risk. Even if only 5% of bonds default, your returns are going to drop dramatically.

Back in September, we looked at three “good” (I think, anyway) funds with good managers. Let’s look at how they have fared.