Bonds are normally issued at par, redeemed at par, and along 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, however 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 incorporate insult to injury, long-term bonds have a top correlation to other financial assets, and they perform abysmally during periods of high inflation.
In general, the characteristics of bonds as a property class are very dismal that you could wonder why any investor will need them at all. Of course, not all investors have similar needs. Many institutions are more thinking 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 complement 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. You want to maximize our return per unit of risk, and bonds don't easily fit into very well. When we plot the risk/reward points for a number of well-known long-term bond indexes from 1978 to 1997, we observe that all of them fall far below the conventional risk-reward line. Not a pretty sight, can 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 within our asset allocation plans: They are able to reduce risk to tolerable levels in a portfolio, and they are able to provide a repository of value to fund future expected cash-flow needs. Of course, we don't expect the bond portion of the portfolio to be a dead drag on its overall performance. It's wise to take prudent steps to improve returns in most portion of the portfolio. Let's take a peek at a number of the common methods employed by fixed-income investors to see if any might advance that goal.
Junk Bonds
Investors undertake more risk when they spend money on lower-quality bonds. While they are able to 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. invest bonds UK They remain hopelessly mired below the risk-reward line.
Active Trading
Most of us understand that the capital value of a connection whipsaws as interest rates in the economy change. So, if we'd an exact interest-rate forecast, we're able to develop 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 fail to predict the correct direction of rate movements, not to mention their magnitude.
Individual bond selection is suffering from the same problems as equity selection. The marketplace 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 every bit 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 the majority of the time, the yield curve is said to be positive. As you can 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 in excess of five years are often 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 significantly steeper compared to slope of the return line.
However, a straightforward 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 sell at a lowered rate. This captures the yield on the bond although it is held, and a capital gain on the difference in price. Throughout the few times when the yield curve isn't positive, simply hold short-term bonds. Nothing is lost since the rates are higher here anyway. While the procedure involves trading, it doesn't require almost any forecast to be effective. The yield curve is just examined daily to ascertain optimum buying and selling points. To work on an after-trading-costs basis, only the most liquid bonds (U.S. Treasury and high-quality corporate bonds) could be used. As time passes, a connection portfolio with an average duration of only couple of years could be enhanced by 1.25% by using this technique.
Foreign Bonds
In theory, at the very least, the largest reason for yield differences between foreign and domestic bonds is currency risk. If you're to totally hedge currency risk, you must theoretically be back at the T-bill rate. But in true to life, opportunities exist to buy short-term foreign-government bonds, hedge away the currency risk, and still have a higher yield. Using these "targets of opportunity" can further enhance a short-term bond portfolio, perhaps by a portion point or two. Of course, if you will find no such opportunities during a particular period, just buy domestic bonds.
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