Bonds are typically issued at par, redeemed at par, and on the way they fluctuate in value as prevailing interest rates change. Their total performance closely tracks inflation expectations. So real growth--if any--is too small to be meaningful. Investors often view them as safe, nevertheless the volatility of long-term bonds may be as high as that of stocks, while their return per unit of risk is anemic in comparison. To include insult to injury, long-term bonds have a higher correlation to other financial assets, and they perform abysmally during periods of high inflation.
In general, the characteristics of bonds as an asset class are very dismal that you could wonder why any investor would want them at all. Needless to say, not all investors have similar needs. Many institutions are far more enthusiastic about matching future liabilities with assets than maximizing total return. For example, life insurance companies can estimate their future liabilities with some precision. Having bonds that mature on schedule allows them to fit assets with expected requirements. Statutory regulations require them to hold bonds to back up their obligations. To oversimplify, insurance companies mark up the cost of providing benefits to compute their premiums. Total return isn't as important as the spread.
That's not the specific situation we face as individual investors, though. We should maximize our return per unit of risk, and bonds don't fit in very well. If we plot the risk/reward points for several well-known long-term bond indexes from 1978 to 1997, we observe that they all fall far below the conventional risk-reward line. Not just a pretty sight, could it be?
Over the 20-year period, various classes of bonds all land well below the risk-reward line between T-bills and the S&P 500 index.
Bonds have only two useful roles to play in our asset allocation plans: They could reduce risk to tolerable levels in a portfolio, and they can provide a repository of value to fund future expected cash-flow needs. Needless to say, we don't expect the bond part of the portfolio to be a dead drag on its overall performance. It's wise to take prudent steps to boost returns in every part of the portfolio. Let's take a look at a few of the common methods employed by fixed-income investors to see if any might advance that goal.
Junk Bonds
Investors take on more risk once they invest in lower-quality bonds. While they can increase total return as they move from government bonds to corporate to high-yield (junk), investors simply don't receive money enough to justify the risk. They remain hopelessly mired below the risk-reward line. invest bonds UK
Active Trading
All of us know that the capital value of an attachment whipsaws as interest rates in the economy change. So, if we'd a precise interest-rate forecast, we could create a trading strategy to reap capital gains. Buying long-term bonds before interest-rate declines will produce gratifying profits. Pretty simple, huh? The problem is, accurate interest-rate forecasts are elusive. Seventy percent of professional economists routinely neglect to predict the correct direction of rate movements, not to mention their magnitude.
Individual bond selection is suffering from the exact same problems as equity selection. Industry is efficient, and finding enough mispriced bonds to help make the effort worthwhile is problematic. It shouldn't surprise us that traditional active management of bond portfolios fails just as profoundly as does active equity management.
Riding Down the Yield Curve
Borrowers generally demand additional return for holding longer-maturity bonds. The connection between maturity and return is expressed as the yield curve. When longer-maturity bonds have higher yields, that will be most of the time, the yield curve is reported to be positive. As you will see in the graph below, yield typically rises very gradually, while risk will be taking off sharply beyond a one-year maturity. On a risk/reward basis, bonds with maturities of more than five years are generally not attractive at all. Hence, investors are well advised to confine themselves to the short end of the spectrum.
As a bond's maturity increases, the slope of the danger line is much steeper compared to slope of the return line.
However, a simple passive technique that I call "riding down the yield curve" can improve yields at the short end of the curve. If the yield curve is positive, simply purchase bonds at an optimum point where interest rates are high, hold them until an optimum point to offer at less rate. This captures the yield on the bond although it is held, and a capital gain on the difference in price. During the few instances when the yield curve is not positive, simply hold short-term bonds. Nothing is lost since the rates are higher here anyway. While the process involves trading, it generally does not require any kind of forecast to be effective. The yield curve is merely examined daily to find out optimum buying and selling points. To be effective on an after-trading-costs basis, only probably the most liquid bonds (U.S. Treasury and high-quality corporate bonds) may be used. Over time, an attachment portfolio having an average duration of only couple of years might be enhanced by 1.25% applying this technique.
Foreign Bonds
Theoretically, at least, the greatest reason behind yield differences between foreign and domestic bonds is currency risk. If you were to fully hedge currency risk, you should theoretically be right back at the T-bill rate. However in true to life, opportunities exist to buy short-term foreign-government bonds, hedge away the currency risk, and still have a greater yield. Benefiting from these "targets of opportunity" can further enhance a short-term bond portfolio, perhaps by a percentage point or two. Needless to say, if you will find no such opportunities during a specific period, just buy domestic bonds.
