I have been writing for a while about how dangerous the bond market is. The price a bond trades for in the secondary market is inversely related to interest rates and we are already starting to see market rates edge higher. There is a huge difference in risk between individual issues of high grade corporate bonds and investing in a bond fund, and it is slightly counterintuitive.
Normally we go into a fund to take advantage of the extra diversification that can be had by combining the assets of the combined investors. However, when a large number of redemptions can force a fund to sell assets at a loss that could be recouped if only given time, the diversification benefit can be far offset by this added downside risk. This is especially the case for fixed income where market prices can trade at a discount to face value, whereas holding any bond issue to maturity will result in the price reverting back to the face value at maturity. This is because a bond always pays face value at maturity, regardless of what interest rates are doing.
With a spread of single issues, however, the company specific risk is much higher as is the effective potential lock in, but this is the cost to pay for fact that if a bond is held to maturity then interest rate risk is effectively eliminated. This is where getting the highest yield with the shortest amount of time to maturity is the name of the game. As you assemble a portfolio of bonds, you want to pay attention to average maturity, but also try to stagger maturities. This way you have cash flows freed up from time to time so that if rates rise you can re-invest a portion of the portfolio at the new higher rate.
Pick triple A bonds if you want to be on the safe side, and diversify as much as possible. Even with a top rated company the whole thing can go belly up due to one of any of a number of reasons, so you have to consider the overall portfolio if any one holding, or also sector went into serious trouble (with bonds it is usually no trouble at all or serious, big trouble). You want to make sure the companies issuing the various bonds are in diverse industries as well so a slowdown or new disruptive technology doesn’t take a big part out of your retirement fund.
While investing safely in a spread of corporate bonds is possible now, my own opinion is that you would be better in the long run to sit in cash until rates really break free rather than lock in to bonds now. This might be years, don’t get me wrong. The length of time governments have held rates artificially low means there is bound to be a serious overreaction at some point. Obviously a balanced approach somewhere in the middle is what you might want to follow, with a large cash reserve and a portion of funds invested in a diverse spread of high quality corporate bonds.
David Mayes MBA lives in Phuket and provides wealth management services to expatriates throughout Southeast Asia, focusing on UK pension transfers. He can be reached at 085-335-8573 or firstname.lastname@example.org. Faramond UK is regulated by the FCA and provides advice on taxation and pensions.