Bonds - Do I need them in my Portfolio?

Over recent years, fixed income has been the place to hold your money, certain strategic bond funds such as M&G’s Optimal Income and Franklin Templeton’s Global Total Return Bond fund have performed extremely well.  It is not just the strategic funds, standard government debt has excelled as many sought safe haven assets over a rather turbulent few years. 

Now the environment for bonds has changed significantly, almost five years on from the credit crisis years of monetary easing from many developed nations has driven up the prices of government and investment grade debt to very high levels, and as prices rise the resulting yield received is diminished.  As such a 10 year gilt today will only return a mere 1.8% per annum.  Well below the 2.8% inflation in the UK.

So why hold bonds now if you are losing money in real terms? This is a good question and many investors have been reducing their exposure to fixed interest over the past 6 months.  As equity markets offer more attractive yields with some equity income funds offering 4% per annum plus the chance for capital uplift many are switching (read more on this rotation from bonds to equities).   The bond market is 5 times as large as the equity markets as many pension funds and insurance companies use debt as liability matching against policies.  Those who require a guaranteed level of income per year and a set redemption amount, bonds are the perfect asset class.  However, for those who have personal pension or investment plans, would you be better placed holding something else?

For diversification and risk reduction, fixed interest plays an important part as it offers a negatively correlated asset class to equities and smooths out returns through yield distributions.  As bond yields are at historically low levels, there will be a point where these rise.  A strong correlation to interest rates would suggest any rise in rates would flow through to the bond market and we would see significant falls in the prices for government and investment grade debt.  One can reduce this sensitivity to interest rates and falling prices by purchasing short duration bonds.  These bonds have a maturity of 1-3 years and focus less on the price and more on the yield received (the most important thing from bonds).  There are not many bond funds available that target a short duration mandate, but if you can access it, AXA’s U.S. Short Duration High Yield bond fund is a great option.

One that has a global bond and currency mandate is Franklin Templeton’s Global Total Return bond fund, ran by an excellent team, Michael Hastentab the head of fixed income at Templeton has positioned his fund in a short duration for the past year and will weather a rise in developed nation rates better than others. 

There are areas of the bond market that still offer attractive returns, emerging market debt, whilst it is more volatile offers attractive yields still. Investec’s Local Currency Debt fund and amongst many have seen 90% returns here over the past 5 years and many see this area as offering a lot more.

Bond’s play a key part in a portfolio and the correct areas and type will be very important when determining how well they do.