Nice and safe and easy.
And on top of that regular income, by using bond funds, investors also saw high levels of capital growth. The fact that the IMA UK Gilt sector has returned close to 300 per cent over the last 25 years only serves to highlight the bond cause.
Of course, you would have made more money from UK equities over that time, but there have been plenty of points over the last quarter of a century where you could have lost out by buying at the top of the market and had to wait for a long time to make your money back.
Performance of indices over 20 yrs
Source: FE Analytics
To not have lost money in stock market volatility over the last 20 years or so, you would have to have been a very watchful and shrewd investor indeed, and therefore probably not reading this in the first place.
Not only has fixed interest been traditionally the safest form of investing, but also investors were well rewarded for holding bond funds.
But is that still the case? One thing is for sure, fixed income doesn’t appear to be as safe as it used to be. Obviously, the chance of governments such as the US and the UK defaulting on their debt is highly unlikely, but there are now other risks involved.
But to address these risks, we need to look back over recent years.
Firstly, given the popularity of the asset class, yields on gilts and other investment grade debt have retreated substantially. That is because as bond prices go, yields are down.
The popularity of fixed interest was because of the level of income you could receive.
Macroeconomic uncertainties also meant that investors piled into the asset class to preserve their capital.
However, after the financial crash in 2008, a new dynamic was thrown into the mix: quantitative easing (QE).
QE mainly involves buying government bonds, forcing yields down further and further.
Ten-year gilt yields had been as low as 1.7 per cent recently and are now at 2.5 per cent. To put that into perspective, they were close to 5 per cent in 2007.
As well as pushing yields down, we are now living in a period of ultra-low interest rates as central banks try to further stimulate the economy by forcing investors into riskier assets.
The major risk surrounding fixed income is that as the global economy improves, central banks may well step away from their QE programmes and will be forced to raise interest rates to curb inflation.
There is much debate among bond managers as to when this may happen.
However, the fear is that if interest rates were to increase dramatically or government bonds were to be sold off aggressively, it could well cause the so-called bond bubble to burst as prices of traditional fixed income assets fall.
Although this so-called bubble has not burst as yet, you only need to have witnessed the recent volatility in financial markets to see that the risks are mounting.
Comments from Ben Bernanke in May stating that the US Federal Reserve (Fed) would taper QE led to an unprecedented upward shift in yields across the fixed income market.
However, it is not just the universal view that yields have to rise at some stage that is causing a stir, but the follow-on of that is the concerns surrounding liquidity.
Experts tend to agree that there are certain areas of fixed income, such as corporate debt, that are very illiquid asset classes.
This is seen as a problem for larger funds more than smaller ones as they could struggle to offload their assets in a sell-off.
This means they either hold those bonds to maturity while other managers can buy new issues with higher yields or they sell their holdings at severely reduced prices.
Either way, it would have a detrimental effect on a fund’s performance.
Stephen Snowden, manager of the Kames Investment Grade Bond fund, explained the situation aptly: "If you run £25bn, 1 per cent of that would be £250m. The market cannot take that; in reality, it can hardly take a fiver."
"Obviously, there are differing views on this matter."
The fact that the Pimco GIS Total Return Bond fund saw outflows of more than $5bn over the last year suggests that concerns over a lack of underlying liquidity in the corporate bond market are valid.
These risks – illiquidity combined with the belief that government bond yields can only go higher – has meant that a number of fund managers have voiced their worries over the future of bonds.
Darwin’s David Jane thinks the bond bubble is bursting. Fund of funds FE Alpha Manager Toby Ricketts, who needs to have fixed income exposure because of sector constraints, says that he does not like the bond funds he holds, but that he has the best of a bad bunch.
Worse still, Ignis’ Chris Bowie said that he was moving his personal money out of his own corporate bond fund because he was so concerned about the outlook for the asset class.
That certainly doesn’t instill a potential investor with much confidence.
So, should investors be buying a traditional bond fund given those risks? As with everything, there are two sides to this story.
Though liquidity is a concern – as even FE Alpha Manager Richard Woolnough said about his £15.6bn M&G Optimal Income fund, there are few bond managers who believe a bursting bond bubble is the likely outcome.
The likes of BlackRock’s Ian Winship and FE Alpha Manager Ariel Bezalel point out that the Fed could not allow Treasury yields to get out of hand because it would scupper any sort of economic recovery.
In terms of interest rates, the chances that central banks will just hike them up seems fairly unlikely, with many suggesting that a staggered approach is a more probable outcome.
Also, though yields have increased recently, it only takes more bad news out of the eurozone or worse-than-expected economic data out of the UK to cause gilts to rally again as investors look for safety.
While Bezalel says such rises in bond yields show that the market has overreacted a tad in recent months, Andy Merricks, head of investments at Skerritts, puts this into perspective.
"In terms of rising interest rates, I don’t think that is going to happen any time this year," he said.
"Things are more deflationary than inflationary at the moment, so bonds could well stay in favour, but it is an accident waiting to happen. Investors’ money is still seeking returns and income and you can still get that from bonds – albeit at lower levels than before."
"There is no doubt that the previous 20 to 30 years will be seen as a freak and I think we are getting back into a new normal. One of the main reasons that the yields on gilts and US Treasuries are so low is because a lot of them are actually owned by central banks."
"They don’t have to sell those, they could hold them till maturity; so selling pressures aren’t a major concern. The real problem would be if inflationary pressures were to come through. Yields and interest rates should stay relatively low for longer."
"It is by no means our investment of choice, but high yield still gives you a higher yield than most other areas. However, that’s not without risk either," he added.
As Merricks points out, there are other options for investors who want to diversify their portfolio.
High yield is lower credit-rated debt. While you get a higher yield – as the name suggests – and less interest rate sensitivity, the chances of default are higher.
Another option could be to use a short-dated fund, which would protect your capital from a possible hike in interest rates in the near-term. However, because those bonds are short dated, you don’t get paid much income.
A strategic bond manager is useful in this situation.
Although there may be readers out there who can, most private investors cannot accurately predict macroeconomic changes or say where bond yields will be in 12 or 18 months’ time.
There is no doubt that investors need to diversify their portfolios, as you couldn’t expect someone who is approaching retirement to hold just equities – it’s too risky.
However, given the reason mentioned above, most investors are not comfortable holding a lot in fixed income either.
Strategic bond managers have the ability to dip into all areas of the market to preserve their investors’ capital and hopefully grow it over time.
You don’t have to give up on income either. Ariel Bezalel’s Jupiter Strategic Bond yields 5.4 per cent, for instance.
Or if investors are concerned about interest rates, there is FE Alpha Manager Richard Hodges’ L&G Dynamic Bond fund.
The majority of Hodges’ fund is set to mature in the next two to three years as he expects to simply reinvest that capital into higher yielding bonds when interest rates finally rise. Both funds have a good track record as well.
They have returned more than 70 per cent over five years, meaning they are the two top-performing funds in the IMA Sterling Strategic Bond sector over the period.
Performance of funds vs sector over 5yrs
Source: FE Analytics
There isn’t an easy answer to this current bond conundrum, but investors may be better off leaving the head-scratching to the professionals so they can use all the tools at their disposal to steer you through.
