With interest rates predicted to fall, many commentators are suggesting we put more money into bond funds. Does this make sense or should we stick to shares and cash?
One of the classic investment theories is that you should diversify your wealth over a range of assets as this helps to smooth out your returns. Traditionally shares, property and cash have dominated the portfolios of UK investors. But in recent years, bonds and commodities have become increasingly popular and many people are saying that now is a good time to put more of your money into bond funds.
The rise of bond funds
Figures from the Investment Management Association, the industry body for unit trusts and OEICs, show just how enamoured with bonds we’ve become over the last decade. Back in 1998 we had £13bn in bond funds, representing 7% of total funds invested. Now we have £80bn, around 19% of total funds. That’s quite an increase.
High returns from bonds in the 1980s and 1990s laid the foundation for this boom. As interest rates fell from the mid teens to the mid single digits, the fixed incomes offered by bonds became steadily more valuable. Indeed, the returns from bonds over these two decades often matched those from shares.
Over the last five years though, interest rates have been relatively stable and the returns from bond funds have stagnated. Unfortunately it was also around five years ago that, for the first time ever, we shunned equity funds and put much more into bond funds. Returns from government bond funds have been around 20% since then, while those that specialise in corporate debt are around 15%. Returns from the UK stock market have been about 50% over the same period.
The long term’s not so pretty either
It doesn’t get any better for bonds if you look at their longer term returns either. Over the past century, they’ve provided returns above 2% a year above inflation, just beating the 1% offered by cash. The trouble is that most bond funds charge 1% a year, so this means the long-term returns you can expect from bonds are about the same as cash but considerably more volatile from year to year.
How have bonds done when shares have struggled? Over the past century, shares have fallen over the course of a year a total of 28 times. On 16 of these occasions, bonds registered a loss as well, suggesting that they’re often not particularly useful when it comes to diversification either.
Why the interest in bonds now?
As you’ve probably already gathered, I’m not particularly a fan of bond funds. Still, numerous articles have appeared recently suggesting it’s a good time to invest in them, citing two underlying themes.
First of all, the Bank of England is now expected to cut interest rates over the next year or so, as it believes the current spate of inflation will work its way out of the system. Secondly, investors have been selling off corporate bonds perceiving them as higher risk in the current climate, meaning that the price differential between corporate and government bonds is greater than it has been for some time. However, this effect this expected to reverse so investors who buy corporate bond funds now could benefit from the double effect of lower interest rates and the narrowing of the ‘spread’ in rates between corporate and government debt.
Hmmm.
Both theories look plausible in my opinion but I’m not convinced that the effects are large enough or long term enough to justify a major shift into bonds. I also suspect that, under these circumstances, shares will do as well, if not better, than bonds. However, that hasn’t stopped net sales of bond funds far outstripping share funds in the first half of this year.
Diversification is essential of course but I remained unconvinced that bonds need to play a major part in this process. Cash seems to do the job just as well as offers much more in the way of stability.
More: Steer Clear Of Corporate Bond Funds
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