Investment: There's no such thing as a risk-free bond

Click to follow
TIME WAS when bonds were regarded as the safest class of investment. The great inflation of the 1970s put paid to that notion.

It is only in the past few years, against a benign background of falling inflation and falling interest rates, that bonds (fixed interest securities) have once again resumed their traditional place as a "safe haven" in the investor's armoury. In fact, so benign has the inflation climate become that, before taxes and costs, returns on many bonds have matched those of shares over the course of the 1990s.

At a time when the yield on shares and savings accounts has fallen to record low levels, it is not surprising therefore that there has been a marked surge of interest in bond funds. The yields on bonds look much more attractive than before.

An era of falling interest rates has given even battle-worn financial advisers with long memories an opportunity to promote the merits of good quality bonds with a fair degree of certainty that they are not risking their clients with the kind of financial meltdown that many bondholders suffered in the late 1970s and early 1980s.

But anyone who thinks that bonds are automatically or invariably low- risk investments needs to think again. The most recent survey of global fixed-interest funds by Standard & Poor's Fund Research, the fund rating agency, demonstrates that, even in the low-inflation 1990s, there are still plenty of ways to make a mess of bond fund investment.

You only have to look at the range of returns achieved by global fixed- interest funds last year to see how real the risks in bond investment remain.

Just taking sterling bond funds alone, the returns ranged from plus 20 per cent to minus 15 per cent; and the range of returns on dollar-denominated funds was wider still. While inflation may be the forgotten spectre at the feast, there are several other factors that can make the difference between success and failure in the bond market. One of the most important, and the one that tends to be forgotten most easily when times are good, is credit quality. Bonds are a form of debt; and the credit-worthiness of the borrower is (or should be) a dominant factor in the way its bonds are priced.

Yet just as investors convinced themselves 10 years ago that Michael Milken's junk bonds were safer than they appeared to be, so last year's summer panic demonstrated that many higher yielding bonds were not as attractive as they had seemed only months before. The Russian debt default and the subsequent collapse of the LTCM hedge fund resulted in a "flight to quality" during August and September.

In the subsequent market brouhaha, prices of emerging market bonds and high yielding corporate bonds in particular took a pasting, prompting losses in several high-profile bond funds as a result. Funds that had the nimbleness to spot the problems coming and were able to buy back into the market at attractive prices later did better, but the overall message of last year was that, despite the taming of inflation, risk does still matter in bond investing.

Another less obvious form of risk within bond funds lies in the maturity profile of their holdings. A bond with a repayment date say 20 years away is inherently more risky than one for which repayment is due in three years time. Funds with relatively high "duration" (the standard industry measure of the maturity of a fund's bond holdings) do disproportionately well when interest rates are falling, but get clobbered more than their peers if they hang on to that position when interest rates turn.

Yet another source of risk is the cost structure of the funds. Just as with equity funds, costs can eat away at the edge in performance that a good bond manager can achieve. The Fund Research survey of global fixed- interest funds shows that a surprisingly large number of funds failed to beat their chosen performance benchmark. As a typical bond fund has a 5 per cent bid/offer spread and a 1 per cent annual management charge, you need a good performance record to have any chance of outperforming an equivalent bond index fund over time.

Bond funds with a strong performance record and an investment process that ensures risk is successfully controlled and managed do exist. The table lists four sterling-denominated international bond funds which have consistent performance records and which also qualify for an AA or AAA rating from Fund Research, based on an assessment of their investment process. On a risk/return basis, all four funds sit squarely in a line between a low-risk, low-return savings account and the higher risk returns offered by the stock market.

It is a measure of the return to normality achieved over the past 15 years that bonds now figure on such a chart at all. Most bond fund managers appear to take the view that some further decline in global inflation is still possible. In other words, we may not yet be at the end of the process which has brought the bond market back to life.

But nobody should be fooled into thinking that all the risks in bond markets have been eliminated. Despite last year's warning shot, many bond funds are taking on increasing credit risk in an effort to boost returns. If there is a recession in the next couple of years, it will catch some bondholders out, as risk does when investment returns are as low as they are at the moment.