Recent financial events have been momentous. Our grandchildren and great grandchildren will probably be studying the credit crisis and all its consequences in their economics courses.
Recent financial events have been momentous. Our grandchildren and great grandchildren will probably be studying the credit crisis and all its consequences in their economics courses.
All investment assets were affected, and bonds are no exception. Bond funds (otherwise known as fixed interest funds) suffered falls. Hedge funds that had borrowed significantly from banks at low rates of interest, and which then purchased bonds that pay higher levels of interest to hopefully generate profits, became forced sellers as the troubled banks called in their loans. Currency movements between the loan currency and that of the bonds also moved to the extent that the potential for profit was lost.
When you have that many sellers, and very few buyers, then the price has to fall heavily. It does not matter how good the product is; if there are too many sellers than buyers the price will fall. The diminished secondary market for bonds meant that hedge fund managers were grateful to get any price for the bonds that they were trying to sell.
Against this seemingly gloomy landscape, many people asked whether they should stay away from these funds or sell their existing bond holdings.
It may seem perverse, but in fact the question should be whether to put further investments into these funds.
Why?
A well managed bond fund will invest in a wide range of bonds, for example, those issued by European companies (depending on the funds? mandate). These companies raise money by borrowing from investors over a fixed term at a fixed rate of interest. A bond is issued at one Pound or Euro; will pay a fixed level of interest each year and at maturity will repay the original one Pound or Euro.
In the interim, the bond can be traded and as such it has a current market value. It seems odd to many investors in the current climate that assets which have a fixed interest and fixed return can have market values which can vary so much during the term; however, this is the case.
In essence, we are currently in a situation where bonds which will mature at one Pound or Euro are being valued at significantly less than that.
To illustrate this by way of an example, a bond is issued for a fixed term of five years with a fixed interest of 6% per annum. During the term its market value falls to half of what it was issued at. For new investors this means that the bond can be purchased at that point with an effective yield of 12% per annum and at maturity it will have doubled in value back to its maturity price.
For investors currently holding a bond fund, although the current value has dropped significantly, they should still be receiving the original annual interest levels and at maturity, irrespective of their current value, the underlying bonds which the fund manager is holding will mature at the initial one Pound or Euro.
So what can go wrong?
The major risk to investing in bonds is that the companies which have issued them default on either paying interest or capital at maturity.
It is worth remembering that in the event of a company going bankrupt and defaulting on its bonds, that bond holders rank higher in the pecking order than shareholders in respect of entitlement to the company assets.
Bond fund managers evaluate companies closely with the objective of managing to stay away from companies which may default on their bonds.
The current values of bonds are at fire sale level. However, subject to the issuing companies not defaulting on their bonds, each bond will redeem at its original issue price and continue to pay fixed interest along the way.
The markets have currently priced bonds in a doomsday scenario and are anticipating that around 70% of issuing companies will not be able to repay the loans. Bond fund managers believe this to be over exaggerated – it is well above the last two recessions and also worse than the Great Depression of the 30s – to the extent that these assets offer good opportunities for both existing and new investors.
With bank interest rates so low, where else will you get an income return of around 12% or higher? Even taking into account defaults, the risk return pendulum is very much in favour of buying these bond funds.
While the fall in prices tests our emotional fibres, a cool analysis must, I believe, conclude that it is a good time to buy, and a bad time to sell.
These views are put forward for consideration purposes only as the suitability of any investment is dependent on the investment objectives, time horizon and attitude to risk of the investor. The value of investments can fall as well as rise as can the income arising from them. Past performance should not be seen as an indication of future performance. You should seek advice from an authorised financial adviser.
by David Franks, Chief Executive, Blevins Franks
