Blog75: Should I Own Bonds Now?

Blog75: Should I Own Bonds Now?

For decades Bonds have been touted as the elixir to an investors' nervous tendencies when investments hit volatility. If you look hard enough it will become clear that the only rationale for having Bonds in your investment portfolio is to help you cope when the market tanks again. Whether it is an existing pension fund or a personal investment you have then you may already have a shed-load of Bonds in there, and you may be very wise in doing so, or not!Let's explore what impact having Bonds in an investment portfolio has, whether times are good or whether times are bad!

We do not react to markets here, we do not run with the topical 'noise' that is flaunted on media, all of that is just noise, and you as an investor would be well advised to ignore it all and stick to your plan. The fact that market volatility has been mentioned in the past week is merely a coincidence, this episode was being created now, irrespective of the noise!

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Quick Recap, What Are Bonds Fund??

Bond Funds are, as the name suggests, investment vehicles that pools investor cash and tracks the rolling price of a basket of Bonds. These Bonds will typically be Government Bonds (as issued by individual countries) or Corporate Bonds, which are issued by large companies. A Bond Fund is not the same as owning an individual Bond. An Individual Bond has a set duration, is issued by a single company or state. With an individual Bond the duration could be short or long, and the level of return you are set to get back (coupon) will vary depending on how 'risky' the provider is. For instance if you were to purchase a 1-year Italian Government Bond right now you would be in line for a yield of 0.5% approx, however if you were to purchase a 1 year Irish Bond you would only be getting 0.008% yield! No matter what way you dice it Bonds have never been hailed as high earners or high 'yielders' however they have always been touted as a source of stability and some return when equity markets (the great companies of the world) take a nose-dive! Many people when investing feel that they ought to have at least a reasonable portion of them in their portfolios, as it provides this level of return when their 'growth assets' portion of their investment tanks (temporarily). Is that a wise strategy or not, lets explore!

3 Portfolios

While it does not exactly mirror the history of equity markets, the 10 years between 2006 and 2016 were a very accurate summary of how the values of the great companies of the world (equity markets) have ebbed and flowed since records began over 150 years ago. The history of equity markets has seen the prices rise considerably, then fall sharply, and then recover more than they had fallen. That is how it has always been. A very sharp fall of 30% or more happens, on average, every 5 years. This fall has always been temporary, and lasts for on average 2 years, by which time the markets have recovered to a point beyond where they were before the fall. And the cycle goes on, always on a long term upward curve. That is how it has always been. If you throw Bonds into a portfolio it will cushion the falls (which you will want!) and likewise cushion the recoveries (which you won't want!).

We took at look at 3 Portfolios over that period of time, Portfolio A was a 35% Equity (Global/Mixed Strategy/Well Diversified) and 65%  Bonds (Diversified Short & Long). Portfolio B was 80% Equity (as above) and 20% Bonds (as above), while Portfolio C was 100% Equity. This will help us determine how Bonds helped, whether we have a significant amount in our portfolios (65%), a smallish amount (20%!) or none ! We will simulate an investment of €150,000 on 1st January 2006, running till 31st December 2015, a 10 year window. A window which contained significant declines (Financial Crisis) and significant gains (Recovery from said crisis!).

Portfolio A, 65% Bonds & 35% Equity:

This Portfolio (not sure if Portfolio should really have a capital 'P' or not!) is one which would typically carry title of a 'Conservative' Fund, insofar as it has less Equities and more Bonds (35/65 respectively). It would be positioned in around a 3-rating on the ESMA risk rating scale, which is the now European-wide standard of rating the volatility of a fund or investment. This would be deemed suitable typically for someone that wants to get a better return than deposit however doesn't want much exposure to 'risk' (which is actually volatility - but that's another days work!).

After investing on 1st Jan it rose steadily to approximately €168,000 by the end of 2007, a nice 15% return or so within less than 2 years, everyone was happy! As we all now know that run was not going to last (it never does!), and in 2008 it hit a really rough period of decline, the Global Financial Crisis, as it was then called!

So how did it perform when the 'markets' plummeted? Interestingly in the March 08 to February 09 period (which was Armageddon you may recall) it suffered it's worst 1-year period, falling 15% in that 12 month period. For a conservative option this is still a hefty fall for an investor to have taken, for example their €150,000 fund value at March 2008 would have been valued at €127,000 in Feb 2009. While not shockingly bad it was nonetheless a trying time for this investor to remain calm and optimistic in the upward curve philosophy. It duly recovered and in early 2009 started a massive rally, which was a welcome note for all investors at the time, even-though our own economy was only beginning to get into the difficulties we would all then endure for several years.

How did it perform when the markets recovered? The period directly following the worst 1 year period it suffered was it's best returning 12 months of the 10 years (it usually always is!). In the period April 2009 to March 2010 it bounced-back over 24%, meaning it recovered and went beyond the height it has been at, now sitting at over €170,000!! If they had panicked in 2008 or 2009 and withdrawn their €127,000 they would have never recovered that money. If it was their advisor who had coached them to remain calm then that advisor has just saved them from a €43,000 mistake!

What happened next? Well the constant upward curve continued for the remaining period up until our study concludes at end of 2015, the value sitting at over €230,000 at December 2015. In the period of that 10 years the investment delivered an annual average return of 4.3%. While this might not sound like an awful lot remember that this is a Portfolio with more Bonds (65%) than Equity (35%). Bonds played a very useful role in smoothing the madness (as you'll see in the next examples!), yet the Portfolio still delivered a reasonable level of return for the investor.

Portfolio B, 80% Equity & 20% Bonds

Portfolio B is a more 'aggressive' Portfolio than Portfolio A, it has a higher weighting of 'Growth Assets' (Equities), and so would be expected to deliver a greater level of return, but also a greater level of volatility. On the ESMA rating this would sit around a 5, which is quite high up that particular scale. Typically this would be suitable to investors who know what they are doing, are capable of handling the volatility and have some time before they would need to liquidise their investment.

Needless to say, this investment follows the same time-line as Portfolio A, and got off to a flyer! It was up from €150,000 to €187,000 in less than 2 years, a 25% return in less than 24 months.

How did it perform when the markets fell? Given that it has less Bonds than Portfolio A it had a bigger fall, and declined in value by 35% in the period January 2008 to December 2008. An investor therefore saw their €187,000 fall to €120,000 in the space of 12 months, which is a very heavy hit to take for an investor. However, if they remained calm, blocked-out the noise and held firm in the belief of the constant upward curve they were rewarded heavily.

So, what happened next? It went on an extraordinary recovery, from April 2009 to March 2010 it grew by 55%, so as of March 2010 it was valued at €181,000. Not quite back to it's height, but it far exceeded that previous high, by hitting a value of €201,000 before the end of 2010! And it hasn't stopped, as of December 2015 it was valued at €270,000, not far off double the value of the original investment only 10 years ago (and having been through the worst financial crisis in many many decades!).

The average return delivered to the investor from Portfolio B, over the course of those 10 years is 5.8%. On the face of it might not sound like much more than the 4.3% from Portfolio A, however the final values of €230,000 (from A) and €270,000 (from B) there is a significant final value advantage from Portfolio B, which had only 20% Bonds. A rockier ride for sure, but one which rewarded the investor handsomely.

Portfolio C, 100% Equity!

Finally we studied a Portfolio which was made up of purely Equity, same high quality diversified equity as above, which held no Bonds at all. This would typically be referred to as an 'Adventurous' or 'High Volatility' option, which sits at the top of the ESMA rating as a '6'. Not for the faint hearted some would say, but it is going all-in on the only asset class in existence that has consistently beaten all other asset classes, and continues on its long-term ascent, even in the face of catastrophic global failures of the highest order. We'll see now how it faired in our studies when compared to the other Portfolios which did contain Bonds.

Like the other 2 it got off to a great start, even moreso as it was fully exposed to Equities, it did not have Bonds holding it back so-to-speak! It hit just under €200,000 within the first 2 years, a huge growth of almost 30% in 2 years. As always this wasn't going to last and so it then was faced with the same financial crisis and the same decline as the other Portfolios in 2008.

How did it manage when markets fell? It came-out the worst, which you would expect, and it fell 40% from Jan 2008 to Dec 2008, a whopping decline. The investor who was looking at a value of nearly €200,000 was now looking at their statement and it read €110,000, which was €40,000 less than they had invested 3 years ago, a bitter pill to swallow (or to ignore). However if they did ignore that, and hold firm in their conviction they were rewarded in a huge way.

So what happened next? The period of April 2009 to March 2010 delivered 70% growth from that low-point, SEVENTY PERCENT, in ONE YEAR! This brought them back to a little under €180,000, which was not back to their previous high but was significantly better than 12 months ago. In addition it continued to surge.

As with the previous 2 Portfolios it went on to continue to grow and as at the end of the study, December 2015 it was valued at €295,500, a few % off hitting double the original investment. This represented an annnual average return of 6.5% for the investor over that 10 year period. It had some very extreme movements over that period, however the fact that it was 100% equity gave it total exposure to the volatile movements, and indeed the upward curve offered by Equities over that period.

Conclusion:

In order to answer the initial question of 'should I have Bonds in my portfolio' or 'should I invest in Bonds now', an investor needs to ask themself what type of investment journey they want to have! For simpicity here is a summary of the 3 Portfolios:

A: Invested €150,000 | Fell by 15% when things were really bad | Final Value €230,000

B: Invested €150,000 | Fell by 35% when things were really bad | Final Value €270,000

C: Invested €150,000 | Fell by 40% when things were really bad | Final Value €295,500

If you were to cut out the middle bit in each description on each of those and were just to focus on the final value figure then every sane person on the planet would take Option C. However it is the 'bit in the middle' that catches most investors out, that enables those that can and do overcome the declines to go and benefit like they do. It will happen again soon (statistically we are over-due it!), and when it does which option do you want to be in!?

Only you can tell if you could overcome and stay the course during those declines or not. If you can't then perhaps having a significant portion of your investment in Bonds is the elixir you need, and if you can then perhaps the world's most consistent and rewarding asset-class is the only one of you. The trouble is there are far too many investors who should be sitting in A yet they are in C, and far too many who should be in C are actually in A......I alone cannot fix that, but I do hope that this research-based and heart-felt piece goes some way towards showing the way to a few.

Paddy Delaney

QFA | RPA | APA | Qualified Coach.

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