Bonds: balancing risk with reward

Bonds are perhaps the least well-understood type of asset. In our article What are bonds and how do they work? we aim to put that right. But even when you have a good grasp of the basics, it’s important to give some thought to the balance between risk and reward which investing in bonds entails. It’s not entirely what it might seem.

While bonds might feel a bit like cash deposits, in that they pay a rate of interest, they are not without risk.

All things being equal, if you bought a bond today and the market rate of interest doubled overnight then the price of your bond could fall by 50%. In other words, you might lose half your investment.

This sort of sharp price movement is uncommon with government bonds issued by countries with strong finances like the UK, the US and Germany. It is also uncommon in the case of bonds issued by financially strong companies, but unseen shocks can result in rapid deterioration of a company’s finances.

Knowing your triple-As from your double-Bs

Both governments and companies are rated on financial strength by ratings agencies and you will often hear mention of triple-A or double-A ratings which signify strength and a good credit risk. Double-B or triple-B on the other hand signifies weaker borrowers.

Some financially weak companies do default on either interest payments and/or repayment of the face value; this is most common when they become bankrupt. And it’s not unknown for financial weak countries to default on their debts, wholly or partially. If this happens, you may not get back what you invested.

In general terms, the best time to buy is:

  • When interest rates are expected to fall
  • Inflation is expected to fall and remain low for the duration of the bond
  • The finances of the issuer (the company or government) are expected to improve    

And the worst time to buy would be:

  • When  interest rates are expected to rise
  • Inflation is expected to rise and stay high for the remaining duration of the bond
  • The finances of the issuer are expected to worsen

However, just like investing in equities, no one can predict the future. For example, the surprise election win for Donald Trump resulted in the price of bonds falling (and the yield rising). This is because President Trump is expected to follow expansionary economic policies, which could result in higher rates of inflation.  

You might be less concerned about the movement in the price of a bond (as long as the risk of default remains low), if you bought it for the long-term and were happy with the redemption yield at the time of your purchase.  

Equities vs bonds vs cash

Historically, bonds have under-performed equities over most long periods but outperformed cash over similar timescales.

The following table shows the real annual rate of return from gilts (UK government bonds), equities and cash over a series of 10 year periods – that is, the annual return after accounting for price inflation. 

Period Gilts Equities Cash
1905-1915 -2.20% -0.20% -0.50%
1915-1925 -1.10% 3.90% 0.80%
1925-1935 10.80% 8.70% 4.70%
1935-1945 0.30% 2.40% -2.30%
1945-1955 -5.40% 5.30% -3.00%
1955-1965 -1.00% 7.30% 1.80%
1965-1975 -5.40% 0.10% -1.40%
1975-1985 5.20% 11.00% 1.50%
1985-1995 6.80% 9.90% 5.20%
1995-2005 5.60% 5.00% 2.90%
2005-2015 3.00% 2.30% -1.10%


Looking at the historic data another way, what is the probability of equities beating gilts over different consecutive periods? As you can see, equities produced better returns over most of these long-term periods, but there are a few periods where gilts do better than equities. Also, there are a few periods where cash does better than gilts.

The following table shows rolling 2, 3, 4, 5, 10 and 18 year periods from 1899 to 2015 inclusive. For example, there are 112 five-year periods that run 1899-1904, 1900-1905 etc. to 2010-2015. Of those 112 five-year periods, the performance of equities is better than gilts in 81 of those periods, giving a probability of equities outperforming gilts of 72%. 

 

Number of consecutive years

 

2

3

4

5

10

18

Total number of x year periods from start 1899 to end 2015

115

114

113

112

107

99

Number of x year periods equities outperform gilts

78

85

85

81

84

85

Probability of equities outperforming gilts

68%

75%

75%

72%

79%

86%

 

The general trend from this data is that the longer you hold equities, the higher the chance that equities will outperform gilts. However, the trend is not as distinct – or the level of historic probability as high – as the ‘equity versus cash’ comparison in our article Shares: why you need to think long term Do bear in mind that these are historic returns only, and do not provide a reliable guide to the future. No one knows what the future might hold and the returns from gilts, equities and cash could be very different in the next 10, 20 or 30 years. 

 

You might also be interested in…

What are bonds and how do they work?

Bonds: when you should and shouldn’t consider them

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