How To Invest In Bonds - Part 1

Sensible Investments with Dr John

Dominic here and it’s my pleasure to welcome back Dr John Wolstencroft who, over two parts, will be looking at how to invest in bonds. This week he covers the low-risk end of the market. In part 2 he’ll look at some of the spicier stuff.

The bond market is enormous, you can make good returns and yet many of us, myself included, are too focused on equities. I think we are put off by the complexities.

This is an excellent overview of the sector. Without any more ado, I hand you over to Dr John.

Government Debt

When a country needs money it cannot raise from taxes, it can’t just issue shares. If it prints money people generally stop trusting it (Zimbabwe, anyone?), so any decent government has to borrow money in the markets. Debt of a fixed duration issued by a government is called a bond, also known as a gilt in the UK or a treasury in the US. 

Government Bonds historically have been very low risk, providing consistent returns. What could possibly go wrong with lending a government money (ie. buying a government bond)? Well, if it’s not your (UK) government you might buy it in dollars or Yen so you might lose money, if the pound strengthens for example. If it’s an emerging market bond (Sri Lanka, Venezuela) you might find the government defaults and you lose your money.

Government bonds are priced off interest rates and inflation. If interest rates at the bank are 2%, why lend money at anything less than 2%? So 3% might sound good enough to tie your money up for a while. But if interest rates are expected to change because of inflation to say 4% next year maybe you would only buy a bond if it yielded 5%. Conversely, that bond yielding 5% will rise in value if interest rates fall back from 4% to 3%.  

So even though the default risk of government bonds is low (Western governments generally pay up), there is interest-rate risk and foreign exchange risk. Interest rate risk is a real concern at the moment because interest rates are rising, not falling, so bonds can be expected to fall in value, especially longer dated bonds (which also suffer duration risk related to variability in the interest rate relative to short dated bonds).

There is a special type of bond, a TIP that is inflation protected. This removes interest-rate risk but if risk is reduced so is return and many observers think that TIPs may have become overpriced, as investors are paying too much for protection against inflation. 

So, what to do? I hope that it should be clear now that the bond market is at least as complex as the equity market.  Fortunately, professionals are there to step in and luckily charges are often very low on bond funds (often under half a percent, nearly always three quarters of a percent or less). Nonetheless this is a low-risk area so returns are going to be pretty low too.