Investment masterclass: Are bonds back?

This is an audio transcript of the Money Clinic podcast episode: ‘Investment masterclass: Are bonds back?’

Brooke Masters
Is it time for investors to get acquainted or reacquainted with bonds? For years, fixed income was seen as the boring dullard at the investment party. You bought it because you had to, not because you were excited. Then last year, the global bond market had its worst year in more than a century. Could bonds get any less popular? But fast forward to today, and many people in finance say that bond markets are still volatile. But bonds themselves are back and worth getting to know.

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Welcome to Money Clinic, the weekly podcast about personal finance and investing from the Financial Times. I’m Brooke Masters, the FT’s US financial editor, standing in for Claer Barrett while she is away. Coming up, everything you wanted to know about investing in bonds but were too afraid to ask. To talk us through the wide, wide world of bonds. I’m joined here in the FT’s New York studio by someone who thinks bonds are anything but boring, Edward Al-Hussainy. Ed, who are you, what do you do and why do you love bonds?

Edward Al-Hussainy
(Laughter) Fantastic. Thanks for having me. I am the global rate strategist for Columbia Threadneedle Investments, based here in New York City. And I do a lot of work thinking about valuation and bonds and what role bonds play in portfolios for investors.

Brooke Masters
Why bonds?

Edward Al-Hussainy
Why bonds? Bonds in many ways allow you as an investor to speculate on the state of the economy in a way no other financial instrument really can. And if you’re like me and you view the world through a somewhat sceptical lens and you are interested in making educated bets about the state of the world, bonds tend to be a lot of fun.

Brooke Masters
Let’s start with something super basic. What are bonds and why do they exist?

Edward Al-Hussainy
Bonds are really a fantastic financial instrument. In fact, one of the first financial innovations. Bonds are an option for you to participate in the income stream generated by an asset. In contrast to equities, which are essentially an ownership stake in an asset, bonds give you the certainty of that income stream, and therefore it’s quite different, but much more stable.

Brooke Masters
What are the different types of bonds?

Edward Al-Hussainy
So largely three core forms of debt out there. One is sovereign debt, which is issued by governments and therefore backed by their ability to raise taxes. Two is private debt issued by companies and therefore backed by the balance sheets and income statements of these companies, backed by their business models and their ability to generate cash. And three is debt backed by the health of households, whether that’s mortgage securities, asset-backed securities that underwrite borrowings like car loans, for example. So three broad classes. Within that fixed-income universe, there is a very special and magical market called Treasuries. Now, Treasuries are instruments issued by the US government. They’re magical because they are the world’s preeminent safe haven asset. Now of course, they’re subject to macroeconomic risks, inflation, changes in fiscal and monetary policy and so on. But they’re a foundational asset, in that every risk asset is valued against Treasuries.

Brooke Masters
Now bonds, you hear about in the news, have different durations. Explain to me how that works.

Edward Al-Hussainy
A duration is essentially how long a bond will exist. So think about it as the lifetime of the bond and therefore the lifetime of that income stream. When you buy into a bond, you are given the certainty of an income stream for a certain period of time. This could range from months on something like a Treasury bill to up to 30 years on a mortgage-backed security. The shorter-term instruments at the moment yield a higher rate than longer-term instruments, largely reflecting the fact that the Fed has been very aggressive in raising rates in the course of the past 18 months. So the three-month T-bill closer to five and a half per cent versus the 10-year Treasury note is around four to four and a quarter per cent in terms of yield at the moment. But you’re able to lock it in for longer periods of time. So you don’t have to worry about that rollover risk or otherwise the reinvestment risk of “What am I going to do with my cash when the T-bill matures in three months, in six months? Am I going to be able to reinvest that at the same yield, or will the yield be lower?”

Brooke Masters
So central banks have been raising interest rates to curb inflation. What has that done to the attractiveness of bonds and how we should think about them as an investment versus something like a bank account which is suddenly starting to yield interest?

Edward Al-Hussainy
Well, definitely makes my job more exciting. We’ve had the most violent repricing in bond markets that we’ve seen really in the course of the past 100 years or so since 2021. Inflation is toxic to bonds, largely because it degrades that real return that investors are looking for. And therefore, the last two years have been quite violent. But I think looking forward, it’s pretty exciting. The interest rate you can earn on a certificate of deposit on a short term instrument like a Treasury bill is quite high, at rates we haven’t seen since the global financial crisis, which means as an investor, you now have a very attractive opportunity to invest in that short term instrument without taking any risk, without taking interest rate risk, without taking the risk of a credit default or a credit event. Now, at the same time, the attractiveness of longer maturity bonds, whether they’re corporate bonds or Treasuries issued by governments or gilts, has increased as well. They’ve become cheaper in the course of the past two years as yields have gone up. So investors are in a very attractive position now where they can both earn a higher risk-free rate on their cash. And at the same time invest at a much higher yield for the long run. And be able to lock in yields that they haven’t seen really in the course of the past 15 years or so. So that’s a fantastic starting point for investors.

Brooke Masters
So you often hear about Treasuries or gilts from the UK government as something that is risk-free. Do you think government bonds are really risk-free?

Edward Al-Hussainy
Nothing is risk-free in markets. That is a fundamental lesson for investors. Now, in contrast to corporate bonds and bonds backed by private assets, what you see in government debt is a lower degree of credit risk. In other words, the probability that a government will default is quite low relative to a company or relative to a household. Where there is embedded risk in government bonds is interest rate risk. In other words, as central banks adjust interest rate policy, the valuation of government-issued bonds will go up and down. And so investors buying into Treasuries or gilts are exposed to that policy risk. So when you purchase a plane bond, it comes with a specific coupon, which is the payment you will receive at a certain frequency, usually six months, sometimes a quarter. So you’ll get a fixed payment at a fixed frequency, and then you will get the principal, which is your initial investment in that bond. You will get it at the end at maturity. When we’re talking about bond prices, we’re really talking about you trading that bond ahead of maturity. So you’ve decided not to hold your bond to maturity. You have decided to sell it. What is the price that you will get for that instrument? That’s the price of the bond.

Brooke Masters
Obviously, if you hold a bond to maturity, you get your original investment back. But the question is what could you have done with the money in the meantime?

Edward Al-Hussainy
Absolutely. So interest rate fluctuations only impact you if you are going to sell a bond. If you hold it to maturity, it has no impact. Your cash flow continues as long as the issuer doesn’t go bankrupt. Two considerations. One, as an investor, you are always looking at the opportunity cost of holding an asset. And therefore, if an asset goes down in value, even though it’s a paper loss, it affects your portfolio and your ability to invest in other assets in that portfolio. Two, you are ultimately interested in inflation-adjusted returns. In other words, the purchasing power of what you’re going to make over time. And if you are in an environment where inflation is going up, the real return on that bond will go down. And so inflation is going to be eating away at your returns faster if it’s fully allocated to fixed income.

Brooke Masters
So basically, if I own a bond with a certain coupon and interest rates rise, the underlying value of my bond goes down. Is that right?

Edward Al-Hussainy
That’s correct. That’s correct.

Brooke Masters
And similarly, if interest rates fall, the underlying value of my bond goes up.

Edward Al-Hussainy
I think you nailed it. That’s exactly it. Yields go up and prices fall. We can get into the bond math behind it. But in essence, that fundamental relationship largely holds for bonds.

Brooke Masters
The other big thing that we’re hearing about right now is the risk of a recession. You know, so far it hasn’t happened. People keep hoping there’s going to be a soft landing. As we look forward and think about doing our investment planning. What would the impact of a recession be on bonds?

Edward Al-Hussainy
If we look at the last 30 years or so, bonds have been exceptionally attractive as investments in a recession. And specifically high-quality debt issued by governments to Treasuries, gilts and high-quality corporate debt, investment-grade debt. The reason that’s played out that way largely is a function of the Federal Reserve and central banks being able to anchor policy around low inflation. They’ve been very effective at bringing inflation down. This is a relatively new phenomena that really starts in sort of the post-Volcker period in the mid-eighties. And since then, bonds have become very effective as diversifier as against equity risk in portfolios. So as an investor having bonds as a buffer against all the downside you see in equities during a recession has become very attractive.

Brooke Masters
Is the idea that bonds won’t lose as much value in a recession as equities, though?

Edward Al-Hussainy
Not only do bonds not lose as much value, but they may actually gain value in the course of recession as investors seek what we call safe haven assets, or it’s assets that are not sensitive to what’s going on in the economy.

Brooke Masters
Got it. So if you’re worried that there’s going to be a recession, you might want to load up on bonds more than if you think life is going to be brilliant and everything’s going to keep flying.

Edward Al-Hussainy
That’s exactly right.

Brooke Masters
Stepping back, if you’re thinking about investing in bonds, is there a rule of thumb for when it’s better to buy bonds themselves and when it’s better to buy, say, a bond ETF?

Edward Al-Hussainy
Several considerations. One, bond ETFs can have certain efficiencies around liquidity. They’re easier to trade. Bonds are traded essentially what’s called on an over-the-counter basis, which means you have to find a buyer and seller to come together. ETFs are traded much more frequently, and therefore it’s easier to find a price for an ETF and discover the price on any given day. Now for retail investors, ETF instruments might also have some tax advantages in terms of taxable events with distribution. So I think in many instances ETFs are quite effective instruments. I would say bond mutual funds, even though they’re quite different from a strategy perspective,  bond mutual funds can be very effective as well, in part because they can access more markets than ETFs currently can, within the fixed income universe.

Brooke Masters
And is the idea that a fund would provide sort of more diversity and an ability to get in and out that a straight bond might not?

Edward Al-Hussainy
That’s correct. So ETFs largely tend to track indices. They tend to be passive instruments that are sampling a very large universe of bonds to replicate the performance of an index. Active managers will take an active view on the economy. So essentially what you’re paying for is a certain degree of insight in terms of what will happen to inflation, what will happen to fiscal policy, what will happen to monetary policy, and you’re paying them to package that in a bond product. That can often be much more effective than an ETF. That’s a passive instrument.

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Brooke Masters
Before we get into exactly how one ought to do the mechanics of investing, we should probably talk now about what are the risks and downsides of bonds, so people are very clear what they’re getting into.

Edward Al-Hussainy
Absolutely. Two key risks. One is interest rate risk. We talked about that inverse relationship between yields and prices. Largely, that’s driven by yields on the risk-free asset. That’s the underlying government bond as yields go up, perhaps as a change of monetary policy that affects bond prices very fundamentally. The second is the credit risk that’s embedded in, particularly in corporate bonds and bonds backed by household balance sheets, asset-backed securities, mortgage-backed securities. The credit risk premium there is essentially the odds that the underlying asset will default, and that will be more cyclical. That goes up and down with the strength of the economy or the strength of that particular side of the economy. And so investors are exposed to both changes in underlying interest rates, often driven by inflation and changes in underlying credit risk, which is driven by the quality of the asset.

Brooke Masters
So I’m interested. I want to get into this bond thing. How much of my portfolio should I be thinking about devoting to fixed income and bond products?

Edward Al-Hussainy
The most important variable for most investors, in my mind, is time. So the question in terms of sort of your allocation to fixed-income allocation to bonds, the first question is: what’s my time horizon here? In general, over shorter time horizons, you want to take less risk and therefore allocate more to bonds. Over a longer time horizons, you might have a higher risk appetite and therefore allocate less to bonds. That tends to be the typical kind of life cycle of a bond investment decision. I’ll add one wrinkle to that. And that’s you want to be opportunistic and you want to be a bit greedy in making the decision and think about the valuation of the asset when you buy into it. In other words, what are you getting for your money? And right now the value for money in bonds versus equities is very attractive.

Brooke Masters
Bonds are a better deal right now.

Edward Al-Hussainy
Bonds are a better deal right now relative to equities, and they’re a better deal relative to equities on the number of dimensions that we’ve seen you know in the past 15 years or so.

Brooke Masters
And that’s partly because they had such a terrible year in 2022.

Edward Al-Hussainy
That’s precisely why they’re a much better investment today, is because they got a lot cheaper in the course of the last year. So a bond investor last year had to suffer through really extraordinary losses. But this year, the starting point is really quite phenomenal.

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Brooke Masters
One thing we haven’t talked about is the famous 60-40 portfolio, which everyone always talks about, which is 60 per cent equities, 40 per cent bonds, which, you know, for decades was what everyone was always telling what you needed to do. Should we still be thinking that way?

Edward Al-Hussainy
I think it’s a starting point of 60-40 portfolio, a fantastic asset allocation tool. It’s, one, simple. Two, it’s cheap in the sense that you can buy an ETF product that embeds that so you don’t have to worry about rebalancing. You don’t have to worry about a high fee structure. You know, 10 or 20 years ago, creating a 60-40 portfolio was a pretty expensive proposition. You know, today it costs single-digit basis points for a retail investor. So it’s a fantastic proposition to start with. And again, the intuition behind that portfolio is that high-quality debt that’s embedded in that 40 per cent will protect you against losses that you see in the equity side of the portfolio. And I think from again, from today’s starting point, that proposition is very attractive.

Brooke Masters
Next question is, OK, I’ve now figured out that I have, say, a 10-year horizon, so I want a fair amount of bonds. I’ve chunky bet of money to put in bonds. Is there a rule for how much I should put into funds versus actually buying a specific bond?

Edward Al-Hussainy
In general, if you are an individual investor, buying a single bond will not be the most effective way to put your money to use. Now, again, if you are a US-domiciled investor, you might do that through municipal bonds and sometimes those will have tax advantages. But in general, trading individual bonds tends to be very inefficient for small-scale investors. And a much more efficient product will be either a diversified mutual fund or an ETF product.

Brooke Masters
If an investor’s thinking about doing all this stuff other than obviously talking to a financial adviser, which is probably always a good move before throwing lots of money ...

Edward Al-Hussainy
Step one. Step one.

Brooke Masters
Step one. Are there other things they should start thinking about as they think, “I’m going to do bond investing”. They want to grow up and be you.

Edward Al-Hussainy
(Chuckles) I think there’s sort of roughly three elements. To start with when you think about investing in bonds or fixed income. One is greed. And greed in the bond market is really personified by the yield. The starting level of yield is very important. It predicts 90-plus per cent of returns over most meaningful investment horizons.

Brooke Masters
So you buy cheap. You make more money.

Edward Al-Hussainy
That’s exactly right. So you want to be sensitive to the starting level of yield. And right now, again, you said yields are 10- to 15-year highs, depending on where you look. Pretty good. Second, I think you want to be a little bit, you know, generous to yourself in terms of your ability to predict the future. Now, whether that’s inflation, more fiscal policy, monetary policy, financial sector accidents. These are exceptionally difficult events. They’re difficult to predict. They’re very difficult to invest around. And what really matters is less your ability to predict them, but more your ability to react to them.

Brooke Masters
OK.

Edward Al-Hussainy
So how you invest, once there’s been a shock, has to be very important.

Brooke Masters
Mm-hmm.

Edward Al-Hussainy
More important than your ability to anticipate that shock, I think, as investors our ability to anticipate significant shocks is pretty poor.

Brooke Masters
Yeah, certainly mine is.

Edward Al-Hussainy
And so in today’s environment, I think it was very difficult to foresee the inflation shock that’s come through. I think it was equally difficult to foresee how quickly inflation’s come down in the course of the last 12 months. But how we react to that shock is going to drive returns for the foreseeable future. And today that starting level of yields is quite interesting.

Brooke Masters
So when there’s an accident and my bond price falls, that means my current holdings look terrible. But I should be looking at the market for opportunities to buy bonds that are now have big yields. Is that ...

Edward Al-Hussainy
That’s exactly right? Right.

Brooke Masters
Gotcha. And you said there was a third point.

Edward Al-Hussainy
The third point is fear. If you are fearful, bonds — particularly high-quality bonds issued by solid companies, by the government — tend to be very good shock absorbers in portfolios. The game in investment is to stay alive over the long term. Not to put yourself in a position where a shock or some sort of unanticipated event will burn your portfolio down and set you back multiple years. You want to be in a position where unanticipated events are offset by some buffer. And bonds remain the best buffer that we have when we think about how we diversify our portfolios against risk.

Brooke Masters
So if you’ve been sort of feeling sick to your stomach watching what happened to your equities portfolio, we know when it goes up and down really rapidly, you should sort of think about bond as your sort of security blanket, that although it will go up and down, it won’t go up and down as much.

Edward Al-Hussainy
That’s right. And again, look, that’s not always true. It hasn’t always been true. No relationships in financial markets are set in stone. Last year was quite unusual in that both equities and bonds did quite poorly, particularly in the first half of the year. Really reflecting what the Fed was doing to fight inflation. That period is largely behind us now, and I think it again opens up this window for bonds to do quite well in periods when equities performed poorly.

Brooke Masters
It all sounds like it’s a good time, “Really, are bonds back?”

Edward Al-Hussainy
I think they are.

Brooke Masters
So for all of you out there thinking about what to do, maybe now’s the moment. Think about your bonds.

Edward Al-Hussainy
Think about your bonds.

Brooke Masters
Thank you so much.

Edward Al-Hussainy
Absolutely.

Brooke Masters
Edward Al-Hussainy is global rate strategist for Columbia Threadneedle Investments.

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That’s it for Money Clinic this week. And we hope you like what you’ve heard. I’ve put some free links in the show notes to help you along your bond investment journey. This episode of Money Clinic was produced by Jake Harper. Our executive producer is Manuela Saragosa. Our sound engineer is Breen Turner. And the original music is by Metaphor Music.

And finally, the Money Clinic podcast is a general discussion around financial topics. It does not constitute an investment recommendation or individual financial advice.For that you need to find an independent financial adviser. That’s the small print over and done with. I’m Brooke Masters, the FT’s US financial editor, and I’ll be back with you again next week. So see you then. Goodbye.

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