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The Lolly survival guide to investing in bonds
Bonds play a big part in many investors' ISAs and pensions. However, experts fear fixed interest stocks are treading on thin ice.
by Gavin Lumsden on Jan 25, 2013 at 11:42
Right now there is a huge debate as to whether there is a dangerous bubble in bonds, which are the loans or IOUs issued by governments and companies when they want to borrow money.
Traditionally, investors have liked bonds because most of them pay a fixed rate of interest. As an asset class in their own right, bonds sit well alongside shares in many people's ISAs or pension plans. Experts say adding bonds to an investment portfolio helps make the returns less volatile.
However, many bonds have become expensive. This video explains what you need to know to understand the crucial debate around fixed interest stocks.
This is the latest video in The Lolly Investor Programme series.
Can't watch a video right now? You can read the transcript instead. See below.
The Lolly survival guide to investing in bonds:
We all like talking about the weather don’t we?
In investment right now the big debate is to what extent should investors be wearing the financial equivalent of snow boots and puffa jackets.
I’m talking about bonds!
Bonds are one of the big asset classes we keep coming back to in this series.
They’re tradeable loans issued by governments and companies.
Traditionally they’ve been seen as defensive, more stable than racy shares.
A good thing to hold alongside shares in your ISA or pension.
The trouble is the outlook for bonds is very cloudy at the moment. There could be danger ahead.
Bonds’ reputation for safety is based on the fact that most bonds pay a fixed rate of interest.
This is unlike shares which might pay you a dividend – or might not.
As a result you kind of know where you are with bonds. Don’t you?
Wrong! Many experts are alarmed that bond prices are dangerously high. They fear the ground on which bond investors walk is icy, that the unwary may take a nasty tumble.
To understand why experts are concerned you have to know what makes bond prices move.
Two main factors affect bonds: the first being interest rates and connected to them the level of inflation.
At the moment interest rates are stuck at an all-time low. At some point they’ll have to rise.
But rising interest rates are bad for bonds because it makes the fixed rate of interest they pay less attractive. Fewer investors buy them so their price drops.
Bonds also hate inflation as it gradually erodes the value of their fixed returns.
The threat of rising inflation hits bond prices because it means central banks will raise interest rates to stop the economy overheating.
Experts worry we’re set for an inflation shock in the future. All the hundreds of billions of pounds and dollars that the Bank of England and the US Federal Reserve have created to avoid a depression could be building up inflation in the global economy.
That would be bad news for bonds.
The second big factor affecting bond prices is the credit rating of the country or company behind the bond.
If the bond issuer is financially strong and has a good credit rating it can borrow cheaply and pay a lower rate of interest.
However, if it’s financially weak and has a lower rating it will pay a higher rate of interest on its bonds.
Historically, government bonds from mature, developed economies such as the UK, US or Germany were seen as rock solid. With top AAA credit ratings they could pay the smallest amount of interest.
Below them were corporate bonds from big businesses. Although investment grade they were not quite so safe and would pay a higher rate of interest – or spread – over what the government bonds paid.
Below them would be financially weak or struggling companies. Deemed non-investment grade they would have to pay an even higher interest rate. They are known as high yield or ‘junk’ bonds.
Last of all were the government bonds from emerging markets which also paid a high interest rate.
The financial crisis has changed all this.
The big budget deficits of the UK and the US mean their government bonds are not as attractive as they used to be. The US lost its AAA rating two years ago and the UK could lose its top credit rating this year.
Nowadays most investors prefer corporate bonds, high yield bonds and emerging market bonds. This is because many big businesses and many of the countries we used to dismiss as ‘emerging’ are in financially better shape than the debt-laden western economies.
So is there a bubble in bonds? Yes, there certainly is in UK government bonds or gilts and US government bonds, known as treasuries.
This is because the Bank of England and US Fed used the QE money to buy their government bonds. Gilt and treasury prices have soared taking the rest of the bonds market, which are priced off these government bonds, with them.
The situation is not quite so serious in corporate, high yield or emerging market bonds but even here prices look stretched. A slump in gilts and treasuries could hit these other bonds too.
The key to what happens is the state of the UK, US and global economies and how much more QE the Bank of England and Fed will do?
If the UK and US continue to dip in and out of recession then bonds will continue to look attractive to some investors, even though they are expensive and their rates of return are poor.
But if there is any sign of a sustained recovery and central banks ending their programme of printing money, bond markets will go into reverse.
All in all, it feels like bond markets are walking on very thin ice.
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