As dividends have been dropping over recent months, is it time to turn your attention to bonds?
Bonds: Attractive Income in the Face of Falling Dividends
Investors constantly search for hot tips on stocks but rarely give much attention to investing in bonds. Bonds are perceived to be boring, technical and even complicated. While I don’t have any ‘hot’ bonds to tip today, I can shed some light on where the current opportunities lie in bond investing.
The Beauty of Investing in Bonds
Simply put, bonds provide predictable income. Unlike dividends, which depend on companies’ earnings and their pay-out policy, bonds pay income periodically. This can be especially important for investors who rely on such income to fund their lifestyle. While stock dividends usually fall during downturns, such as the current stock market condition where many dividends are off the agenda, bonds, especially high quality bonds, are far less likely to experience a similar reduction.
The strategy of diversifying portfolios, spreading investments across stocks, bonds, and other assets, has always been a main principle of safe, long-term investing. Bonds, in general, are less volatile than equities. Traditionally, sovereign bonds, such as US Treasuries and UK Gilts, have had low correlation to equity markets. As a rule of thumb, bonds tend to provide a hedge to equity risk, enhancing risk adjusted returns in an all equity portfolio.
The sheer velocity of the equity market declines from late February through to late March, prompted by the coronavirus pandemic, saw a rise in the demand for US treasuries, pushing US Treasury yields to all-time lows. As a part of the rescue effort, the Federal Reserve (Fed) reduced interest rates to near zero which, together with the elevated prices, made the Treasuries less likely to provide much return to new buyers.
On the other hand, credit spreads (the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality) widened sharply in March as panicked investors fled corporate bonds, creating buying opportunities. Credit spreads have an inverse relationship with bond prices, the wider the spreads, the cheaper the bond prices. Furthermore, the Fed pledged to do whatever it took to shore up liquidity in the financial markets by buying bonds. Fed purchases are no longer limited to Treasuries and Mortgage Backed Securities (MBS); for the first time it has extended purchases to include Investment Grade (IG) and High Yield bonds (HY) downgraded from IG. The bond market has since calmed down and seen credit spreads contract but there is still a long way back to the level of January, meaning that opportunities still exist.
Concerns and Opportunities
One main concern in the current economic environment is the prospect of rising default rates; companies either skipping coupon payments or not being able to repay bondholders on time or at all. The other main concern is credit rating downgrades, particularly pertinent for IG bonds. If an investment bond gets downgraded to sub-investment grade ratings, known as high yield, this can trigger forced selling by institution investors that are only allowed to invest in bonds with stronger credit ratings.
When selecting corporate bonds, shorter-dated bonds from high quality issuers, especially in defensive and noncyclical sectors, could provide income at attractive valuation while lowering the default risk and credit risk. Non-agency MBS could be a high quality alternative to corporate bonds. In addition, MBS and Asset Backed Securities (ABS) are not widely held by passive structures so are less susceptible to a market sell-off while still offering stable income.
Let the experts work for you
The Bond market is fairly technical and to master it requires deep knowledge, not only of issuers but issuances as well. Plus it is less feasible for retail investors to purchase individual bonds. Bond funds below specialise in various bond structures, which can provide exposure to more predictable income. Though the past performance is not an indication of future, these funds have managed to generate attractive yields since their launch.
GAM Star Credit Opportunities seeks steady high income in good quality companies, more specifically investing in subordinated bonds in investment grade issuers. It has a preference in the subordinated and hybrid debt issued by insurers and banks which have strong capital position to maintain higher coupon payment. The portfolio holds a mix of fixed and floater bonds to mitigate interest rate risk. The current yield of the portfolio is 4.5%.
Rathbone Ethical Bond aims to provide a regular, above average income through investing in a range of bonds and bond market instruments that meet strict financial and ethical criteria. The portfolio currently generates a yield of 3.6%. It is significantly exposed to the Banking and Insurance sectors, accounting for roughly 75% of the portfolio, where muted dividend pay-outs imposed by the regulators bear no impairment to the coupon payments.
TwentyFour Monument Bond aims to provide an attractive level of income relative to prevailing interest rates whilst maintaining a strong focus on capital preservation. The portfolio only holds investment grades, of which over 44% is in AAA ratings. Over 63% of the fund invests in UK residential MBS and the rest invests in various European ABS market. The fund currently yields 1.49% whilst bearing minimum interest risk.
All information given including prices, yields and our opinion is correct at the time of publication. Our opinions on investments can change at any time and for our latest view please go to www.share.com. To understand how our Investment research team arrive at their views please read our Investment Research Policy.