“Where there is no alternative there is no problem.”
- James Burnham

We’ve just lived through a unique time in the history of investing. An era of low interest rates and accommodating monetary policy temporarily changed the way investors saw the world. The phrase of the day was ‘there is no alternative’ or ‘TINA’ for the acronym loving financial services industry. The level of interest rates meant cash and bonds earned practically nothing.

Many investors figured there was no point in investing in anything but shares. Some investors sought growth shares. Some preferred alternative assets including venture funds and private equity. In Australia many investors turned to dividend paying shares with our returns turbo-charged by franking credits.

The unprecedented speed of interest rate increases changed the equation. The new environment was on display with the declaration that bonds are ‘back’ by almost ever speaker at the Morningstar Investment Conference for individual investors. Perhaps they are but the case may not be as cut and dry as it appears.

Bonds 101

The bond market is large and diverse. For the sake of simplicity we will focus on the biggest part of the market. Investment grade issuers who pay fixed rates of interest. These are companies and governments that investors believe are not at risk of default and who promise to pay investors a set amount of interest each year over the life of the bond.

Buying an individual bond from an issuer that does not default is a straightforward investment. If the bond is purchased at issuance and held to maturity the annual return will equal the interest rate. A bond has a coupon rate which is the amount of interest that will be paid each year. The par rate of a bond is the amount of money that will be returned to an investor at maturity. A bond with a coupon rate of $30 and a par value of $1000 will provide an investor with a return of 3% annually if it is issued to an investor at par. Simple enough.

Over the life of the bond the price will change based on how the coupon and par value compare to prevailing interest rates. A simple example will illustrate these price changes. If interest rates increase on the issuer to 5% nobody would buy the same bond for $1000 with a par value of $1000 and a $30 coupon. This would make no sense. An investor would rather buy a newly issued bond with a $50 coupon. That is a higher return so an investor will demand a lower price on the previously issued bonds to equalise the return.

There are several other factors that are at play. Once again for simplicities sake we will ignore them because the biggest influence on bond prices when the credit worthiness of the issuer is steady is the direction of interest rates. Rates going up will make bond prices go down. Conversely rates going down will make bond prices go up.

Over the past few years as interest rates have gone up bonds have plunged in value. Yet on the surface this makes bonds more attractive. Interest rates have gone up which means buying a newly issued bond would mean higher returns for investors who buy individual bonds and hold them to maturity.

How does the bond market look for individual investors

The return on individual bonds that are held to maturity is clear. It is the interest rate of the bond. The problem is that individual investors generally cannot buy an individual bond in Australia. Individual investors must turn to ETFs and funds to gain access to this asset class.

Things are slightly more complicated when buying a fund or ETF. A fund and ETF is a basket of bonds. The good thing is that a basket of bonds provides instant diversification in a single transaction. However, there are implications to this. The basket of bonds will never mature. Some bonds in the portfolio will mature but new ones will be added.

An investor cannot lock in a return because there is no way to get money back at maturity. The ETF or fund will have to be sold at some point in the future and the return will consist of the distributions from the ETF and fund and the differences between the purchase price and sale price.

Holding onto an individual bond until maturity means an investor does not have to worry about interest rates or any of the other factors that influence the price of a bond. The return is locked in. Buying an ETF or fund means the changes in bond prices matter a great deal. This is why investors in bond ETFs and funds have had such a poor experience in the past couple years.

We can use a popular bond ETF as an example. The Vanguard Global Aggregate Bond Hedged ETF (ASX: VBND) invests in overseas bonds with currency risk removed. The average time to maturity of the bonds in the portfolio is 8.8 years and it is passively managed. Since January 1st 2020 the ETF has dropped 26%.

For bonds to be ‘back’ an investor purchasing an ETF or fund must not simply look at today’s interest rate but also be confident that bond prices will not continue falling. Interest rates are not just controlled by central banks. Investors get a say as well.

We have seen this recently as the 10-year yield on US treasury notes has increased from 4.3% to 4.7% in the last month alone. This interest rate rise was not based on the Federal Reserve raising interest rates. The last increase was in July. There are other factors at play.

The supply of bonds plays a role and investors were spooked when the US Treasury announced that 3rd quarter issuance would be around $1 trillion – that is trillion with a T. In 90 days.

Inflation also plays a role. A fixed rate bond is a terrible investment in an inflationary environment. The interest payments are locked in but the value of those payments in real or inflation adjusted terms keeps dropping. More on this later.

Bonds vs. dividends

Now that there is an alternative some investors may turn away from dividend paying shares and purchase bonds. We haven’t seen this yet in Australia but in the US dividend paying shares have underperformed significantly year to date. A popular US listed dividend ETF the iShares Select Dividend ETF (NYSE: DVY) is down around 10% this year while the S&P 500 is up around 13%.

This underperformance can at least partially be attributed to investors choosing higher yielding bonds although the AI driven run up in technology shares that dominate the S&P 500 played a large role.

Reassessing dividend paying shares in a higher interest rate environment makes sense for some investors. Particularly large institutional investors who can buy individual bonds and lock in the higher interest rate for the life of the bond. The picture is less clear for individual investors that are forced to use ETFs and funds to access interest income.

Dividends have a major advantage over interest income because they tend to grow over time. According to Standard & Poor’s, since 1989 S&P 500 dividends have grown an average of more than 6% a year. That is significantly above inflation during the same time period which means that an investor would have grown their real or inflation adjusted income stream over that period.

The fact that dividends grow makes current comparisons between dividend yields and interest rates less meaningful. For a long-term investor the real question is what asset class will produce a higher stream of income in the future. It is hard to argue for bonds in that scenario.

We can also compare the difference between the interest available on cash and what we get from bonds. Right now cash looks pretty attractive compared to bonds. Cash does come with reinvestment risk because you can’t lock in an interest rate over the long-term. The problem is that as an individual investor you can’t do that anyway with a fund or ETF.

In a recent episode of Investing Compass we explored if you could retire on dividends. 

What role do bonds play in investor portfolios

Bonds have traditionally offered lower returns and lower risk as measured in volatility terms. Adding bonds to a portfolio will lower the expected return of the portfolio but also cause the portfolio to bounce around less in price.

The role that bonds play in my own portfolio is a little more straightforward. They play no role. I don’t own any and I don’t intend to buy any despite the proclamations that bonds are ‘back’. There are several reasons for this. They are all related to my personal goals and circumstances and may not apply to other investors.

The first consideration is that volatility is not the way I define risk at this stage of my life. I am still a long-term investor. I’m more interested in having a greater allocation to growth assets which should deliver higher returns over the long-term. The biggest risk I face is not achieving my goals.

I am trying to generate income from my portfolio. Yet even with the increases in interest rates bonds still fall short. Not only do I want to generate income but I want that income stream to grow over time. The only way for the income to grow that is generated from a bond ETF is for interest rates to keep going up. The basket of bonds in the ETF will then start to include more and more bonds with higher interest rates. The issue is that for this to happen the ETF price would decline as the increase in interest rates will lower the value of the existing bonds.

For the price of the ETF to go up interest rates will have to decrease. For that to happen inflation will have to come down which will lead to central bankers cutting rates. I don’t buy it. I think rates will stay higher for the foreseeable future. In my opinion there are too many structural changes in the economy that are inflationary. I think inflation is going to be sticky and a heavily indebted world will continue to issue more debt as companies and governments are buried as the mountain of debt resets to higher interest rates.

It is always worth while for an investor to consider alternate scenarios. What happens if I am wrong? In this scenario inflation is quickly brought under control. Interest rates fall which bails out heavily indebted companies and governments. The economy is stimulated. And bond ETFs increase in price.

In this lower inflation and low interest rate scenario something else would happen. Share prices would likely skyrocket even if there was temporary dip in response to a recession. Something that would be positive for my portfolio. My scenario wouldn’t be great for shares. But in periods of high inflation, shares have historically outperformed bonds. Especially on a real or inflation adjusted basis. A company can pass on at least some of the price increases to consumers.

Bonds are undeniably more attractive than they were a few years ago. There are still lots of things to worry about with bonds as my colleague James Gruber pointed out in his recent piece. Given my own particular circumstances I am happy holding some cash and an equity heavy portfolio that is focused on generating dividend income. Bonds may be back but I’m sticking with my strategy.