Traditionally, bonds have been used to dampen the risk of equities. But concern is mounting that, after many years of strong performance, bonds have become a bubble that’s about to burst. So, how worried should we be?
Sensibleinvesting.tv has been to meet David Plecha, Chief Global Fixed Income Portfolio Manager for Texas-based Dimensional Fund Advisors, who’s in London on business. Perhaps surprisingly, given the current angst about bonds on both sides of the Atlantic, we found him to be in a fairly relaxed mood.
SITV: We’ll come out with it straight away... are we in a bond bubble?
David Plecha: In general, bonds are less risky than stocks. If you’re looking for a way to regulate the risk of your overall portfolio, bonds are an excellent way of doing that. That doesn’t mean that bonds are without risk. There always has been, and always will be, risk in bonds. There’s term risk, so if interest rates go up, bond prices go down. What people are asking is, in this particular period, isn’t it more likely that rates are going to go up because they are so low? So they’re saying it’s a bubble.
One example I give is Japan. Interest rates have been very low there for a very long period of time. In Japan, they’ve got tired of calling it a bubble because it’s just not going away. Just because rates are low doesn’t mean it’s a foregone conclusion that they have to go up immediately or in some violent fashion. They could stay low for a very, very long time. Bubble is a term that is thrown around way too loosely. Simply because rates are low, I wouldn’t say we’re in a bond bubble.
SITV: OK, so we might not see the kind of crash that occasionally occurs in equity markets, but things aren’t going to get very much better for bond investors than they are now. So is there a case for reducing exposure?
DP: It comes down to tolerance of risk. If investors are feeling uncomfortable with the amount of term risk their manager is taking, they should consider it. I wouldn’t try to forecast interest rates. Rates are notoriously difficult to forecast. Investors should line up the risk they’re taking with their tolerance of risk.
We’re in a period where a lot of investors feel they need to reach for yield, that yields are too low and they should reach for more. They’re stretching out the curve for more term risk or reaching for more credit risk than they might be comfortable with. And when you get that misalignment between the amount of risk they’re taking and what they can really tolerate, that usually ends badly.
SITV: The general rule traditionally is that your age should match your percentage exposure to bonds. Was that ever good advice?
DP: Asset allocation is a very complex matter. I think it’s impossible to give a rule of thumb like that. There are plenty of younger investors who may not be tolerant of equity risk. They should not feel forced into it because someone’s saying, you’re this age so you should invest this way. If that doesn’t allow them to sleep at night, then it’s not the right investment.
Likewise, older people may be in a position where they’ve done very well, relative to their spending needs. If they’re comfortable with equity risk, they shouldn’t feel compelled to get out of it. Age is a factor - I’m not denying that, but there are lots of other factors involved, and you can’t boil it down to a simple rule.
SITV: Of course, there are several different types of bond - government and corporate, short and long, and so on. We’re assuming you would recommend a healthy mix?
DP: A nice healthy spread is probably a good starting-point. The one thing I would caution against is structured debt products. We think, “I can gather up a pool of assets, like sub-prime mortgages, and I can just slice it and ice it and create a AAA-rated security.” I would be very sceptical about the notion that somehow, with enough engineering, we can generate bonds that can pay more than the risk might suggest. Risk and return are related. Even in the good times those securities were notoriously illiquid, and then of course when the financial crisis hit there was no bid side to the market. There are no free lunches out there - that would be my main message.
SITV: Historically, the two main cautious alternatives to bonds have been cash and gold. But both of those are looking unattractive for different reasons at the moment, aren’t they?
DP: You could think of cash as the least risky of all bonds. It’s the shortest end of the bond spectrum - an overnight security. For folks who have no tolerance of risk, that’s where they would go. We’re in a period now where cash rates are very low - in fact they’re lower than inflation rates. That makes it a very painful place to be, because by being in cash your purchasing power is decreasing; you’re losing relative wealth. But, again, I worry about people saying, “OK, I’ll do something just to get more yield,” even though it’s outside their comfort zone.
SITV: And what about gold?
DP: As an investor, I have capital to invest - I’m going to provide capital to a company, in the form of equity, or to a government, in the form of bonds, and I expect a return on my capital. Now I know that comes with risk, but that’s the basic game. In gold, you’re not really doing that. You’re buying a lump of a mineral and then just sitting there. And the hope is that it’ll serve as a hedge against inflation. If prices go up, then this thing will go up too. But, in the end, why should gold do any better than inflation? It’s hard to give an answer. I’m a little sceptical about gold as a stand-alone investment.