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Your bond questions answered

Cuffelinks reader, James, has some additional questions covering: bonds for capital gain or income, bonds in a growth strategy, passive vs active investing, unconstrained bond funds and duration risk.




Warren Bird’s previous article, An idiot’s guide to bond funds, was written in response to a message from James, a Cuffelinks reader, who asked for an explanation of bonds in layman’s terms. This article wraps up the series, addressing the remainder of James’ questions. Warren has again stepped in to provide his insights into the realm of bonds:

Should one invest in bonds for income or capital gain?

Bond returns are income returns over time; you can speculate about short term market movements if you want, and try to time your entry to achieve capital gains, but the nature of bonds and bond funds is income returns.

Are there some bond funds that should be included in the growth section of a portfolio as opposed to the defensive?

Funds that invest in lower rated corporate bonds and high yield are more closely correlated with equity market returns and thus don’t perform the same defensive role as a portfolio of Australian government bonds. But they still aren’t ‘growth funds’ so they don’t belong there. Some funds have a category for ‘middle risk’ or ‘alternative defensive’ assets that they put credit and high yield into.

Is a 70/30 split crazy when interest rates are at all time lows?

Not in my view. The concern seems to be that bonds will perform poorly when rates go up. However, just because rates are low doesn’t mean they are going to go up significantly; even if they do, it means your expected future returns will ratchet up as rates go up. And equities are pretty fully valued so it’s quite possible that they will fall sharply when bond rates go up.

What are the merits of passive vs active investing in bonds (it is my understanding that most bond funds have underperformed passive funds over the past ten years, much like active equities funds)?

It’s not true that most bond funds have underperformed – in fact, most have outperformed passive funds. The issue for many super funds, etc is that the amount of outperformance from bonds is much less than in other asset classes, so they would rather allocate fees to seeking higher excess returns than bond managers can deliver. I think you should focus on after-fee returns and if you can get value add from any asset class you should be willing to pay for it.

Please explain these new-fangled ‘unconstrained bond funds’.

The gist is that they are funds that try to get value out of trading short term views of bond markets and sometimes equity markets, too. The specific strategies are unique to each fund and the skill set of the managers on their team.

Are they just a fad?

I gave a short response to this very question in the comments section of this piece, What’s that UBS bond benchmark in the annual statements?. I personally invest in them so I don’t think they are a fad. They have a place in the risk-return spectrum.

Are they a genuine solution to the duration risk argument?

That’s not the reason I would invest in them. Duration risk is worth taking – with positively sloped yield curves you get paid to take duration risk.

Have they been created in response to bond fund managers wondering where the next dollar will come from after a 30 year bull market?

No doubt that was the motivation for some of them, but since most of them were developed several years ago before talk of ‘the end of the 30 year bull market’ took hold, it’s probably not true for the sector as a whole. A less pejorative view is that end-investor demand for more income-focussed products that weren’t constrained to just bonds led to products being developed to meet that demand. I personally think that funds with duration have a place in many portfolios and I have some in my own SMSF.

 

Warren Bird was Co-Head of Global Fixed Interest and Credit at Colonial First State Global Asset Management. His roles now include consulting, serving as an External Member of the GESB Board Investment Committee and writing on fixed interest. His comments are general in nature and readers should seek their own professional advice before making any financial decisions.

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