Choice 1: Shorter vs. longer
Over time, the return that you receive from owning bonds is closely related to the yield-to-maturity at the time you buy them. If you hold a bond to its maturity date, that is the return you will receive assuming all coupon (interest) payments are reinvested. Using UK government bond (gilt) data from 1970, we can run a simple analysis and look at the average yield-to-maturity of bonds from 1.5 years maturity up to 15 years. The results are plotted below, against the volatility of returns of a constant maturity bond portfolio at each chosen maturity. What is evident is that there is very little yield pick-up from owning longer-dated bonds than shorter-dated bonds (around 1% p.a.), but the risk level picks up dramatically. Note that during this period the annualised volatility of returns (risk %) of global equities was measured at around 15%. On this basis, 15-year bonds had around three-quarters of the risk of global equities compared to just over one-third for 5 year bonds.
Choice 2: High quality borrowers vs. low quality borrowers
The roles that bonds play in both more cautious and more adventurous portfolios are primarily defensive. As one moves away from the strongest borrowers (AAA and AA), yields rise as borrowers become weaker. As one slips below investment grade (any bonds rated below BBB) into ‘high yield’ bonds, investors take on a greater degree of the risk. Lower quality corporate bonds have an increasing correlation to the borrower’s equity, reflecting the risk of default on their debt. At times of equity market crisis – when weaker companies may be in trouble – higher quality bonds tend to perform better than lower quality bonds, providing a useful defensive holding in a portfolio, as the figure below illustrates.
Choice 3: Hedged vs. unhedged
Buying foreign bonds increases the opportunity set for investors and diversifies the risk of interest rate movements across markets. A foreign bond comes with currency risk between the currency of issue (e.g. US dollars) and the base currency of the investor (e.g. Sterling for a UK investor). Currency exposure introduces an equity-like risk into the bond portion of portfolio, creating a volatile asset. Let’s run a quick experiment. For simplicity’s sake, imagine that you placed a deposit in US dollars for one month and rolled it over each month without hedging the currency, from 1990 to 2022. Imagine too, an alternative scenario where you hedged the US dollars back to GBP, in effect ending up with a synthetic GBP cash deposit, as the cost of hedging is calculated using the difference between the two interest rates (unfortunately there are few free lunches in investing!). The chart below reveals the material difference in annual outcomes.
Investors need to be able to talk themselves out of a sensible starting point of shorter-dated, higher-quality, currency-hedged bonds, when deciding what type of bonds to own.
