It is worth noting here that investing in global bonds would carry an element of currency risk. I do not like to add unnecessary risk to our bond exposure, and so prefer funds where the currency risk is hedged.
The hedging slightly increases costs, but the increase is relatively modest and much smaller than the margin charged by actively managed funds over more passive funds.
Thirdly, it is important to remember that bonds carry not only credit risk but also duration risk, with longer-dated bonds and gilts being much riskier than shorter-dated bonds. With interest rates set to rise over the next few years, duration risk will come increasingly into play. This has led to the launch of more shorter-dated bond funds from the likes of Vanguard and Axa. These have added further sub segments into the bond marketplace and greater choice for investors.
Finally, there is the liquidity risk, with the bond market seeing such strong inflows over the past six years. There is a concern that when interest rates rise and prices fall, there might be panic selling by retail investors, which in turn might force funds to dispose of their bond holding at whatever price they can obtain.
The main defence against this is to ensure that your portfolios are invested for the longer term and that you would not be a forced seller at times of volatility.
This can be achieved by ensuring that you have a good cash buffer. Yes, this will have an impact on overall returns, but that could be far less damaging than having to sell when the market is at rock bottom.
So when making a decision, its worth bearing in mind:
■ The issue of rising yields has been much talked about in the press and market commentators for more than three years. Sitting in cash over that period would have given up almost 1.5 per cent a year in yield
■ There is no way of knowing when future interest rate rises will occur, and trying to time such a move is likely to be a futile exercise
■ Owning short-dated bonds provides a mitigant, but periods will exist when short-dated bond returns provide poor and potentially negative returns
■ Cash is not a safe alternative, as it has lost more than 3.2 per cent a year in real terms. This translates into a loss of more than 15 per cent on a cumulative basis over the past five years
■ Last year’s market concerns of slowing of US quantitative easing is a reminder that bond prices are likely to remain volatile
So in summary, while bond returns are likely to be lower over the next five years than they have been in the past five years, bonds still play an important diversification and risk manager role in portfolios. Short-term volatility can be managed by ensuring sufficient cash is retained to meet any short-term need.
