Why this investment type shouldn’t be ignored

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In our latest episode, we tackle a topic that a listener asked us to cover: how bonds work and the role they play in a portfolio. Joining Kyle to cover all things bonds is Damien Hill, manager of BNY Mellon Rspnb Hrzn UK Corp Bd InsWAcc (B8KDLX4)fund. Areas discussed include how bonds are heavily influenced by inflation and interest rates, different risk levels, and why bond yield levels today offer investors greater protection compared to over most of the past 15 years.

00:00-00:51 – Intro 
00:51-04:06 – Bonds defined and how they work explained 
04:06-07:14 – Bond credit ratings 
07:14-08:34 - What to know about bond yields 
08:34 to 10:17 – How interest rates and inflation influence bonds 
10:17-12:14 - Why bond duration is an important metric 
12:14 –15:17 - Outlook for bonds 
15:17–18:24 - The role bonds play in a portfolio 
18:24-20:28 - Main considerations for UK gilts 
20:28-23:27 - Bond opportunities and risks 
23:27-24:15 – Outro

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to our latest On The Money podcast episodes, a weekly show that aims to help you make the most out of your savings and investments.

The topic for this episode came from one of our listeners who pointed out that while we do mention bonds on the podcast, it’s not an area of regular focus. Due to this, the listener asked if we could have an episode dedicated to how bonds work, how they fit into a broad income-focused portfolio, and there was an additional request to cover both individual bonds and bond funds.

Joining me to tackle this topic, is bond fund manager Damien Hill, who manages the BNY Mellon Responsible Horizons UK Corporate Bond fund. Damien, thanks for coming in today.

Damien Hill, manager of BNY Mellon Responsible Horizons UK Corporate Bond: Thanks so much for having me on today to talk about all things bonds. I’m looking forward to it.

Kyle Caldwell: So, Damien, when you strip everything back, a bond is essentially an IOU or a loan that investors make to governments or companies. In exchange, the bond offers a fixed amount of income throughout its life. 

The income element is known as the coupon, which is paid twice a year. If the government or company that issues that bond proves to be creditworthy and doesn’t run into financial difficulties, then the amount you invest, known as the principal, is paid back to you when the bond matures.

It’s very important to bear in mind that you don’t have to buy a bond when it’s issued. You don’t have to hold on to it until it matures. You can buy and sell in the secondary market.

So, Damien, I’ve just offered a very brief overview. Could you unpeel the onion further and talk about bonds having a price and a yield, and how that is an inverse relationship?

Damien Hill: That’s a really good summary to start. Clearly, there’s a lot of complexity in bond markets, but you’ve summarised it in the most simple way there that you get effectively a contractual amount of income every period, and you get your money back that you’ve lent to the borrower.

There’s clearly a lot of variety in there. You can have bonds that are linked to inflation where the extra income you get, the coupon, every period goes up or down linked to the inflation rate or occasionally you can buy bonds called floating-rate bonds where, again, the amount of income you get each period will adjust with underlying interest rates. 

But for most of the bonds, that characterisation is correct. You get a fixed income or a coupon every period. Some pay annually, some pay semi-annually. Those floating rate ones I talked about can pay quarterly because the coupons, that income, is reset every quarter.

In terms of the interaction between yield and price, because a lot of those bonds as you [said], the income is fixed and you get a fixed amount back, the amount you’ve lent to the borrower. Clearly, the creditworthiness of companies can change through time, the interest rate environment can change, inflation rates can change.

So, the amounts a borrower or a bond investor might require to lend to a company or a government shifts through time, and that required rate of return through time is what we call the yield.

So, a bond, when you look at the maths, is effectively a collection of cash flows, and you do what we call a discounted cash flow analysis where effectively you bring the value of that income, those coupons, and that redemption that you get back - the payment at the end - back to today’s value. And the rate you use to do that is the yield. 

So, that’s the required rate that shifts through time. So, if the required rate goes up, the value of those cash flows and that redemption payment today falls in value because the hurdle rate, that yield, has gone up. So, then the price falls. So, you have an inverse correlation between the yield or rate of return required and the price.

Because effectively, that income stream is locked and fixed. Essentially, the price shifts around depending on how much return people require at any point in time.

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Kyle Caldwell: Let’s now move on to risk. So, bonds are given a credit rating that determines the risk level of a bond. If I was to try and explain it in a quick way that people might hopefully understand, it’s a bit like how GCSEs used to be graded. So, in the bond world, a bond with a rating of AAA is considered the best, the highest quality, and it goes all the way down to U for unrated.

Could you talk us through how bonds are rated, and also explain what the terms ‘investment grade’ and ‘high yield’ mean?

Damien Hill: Yeah. I think you summarised that really well there. So, there’s three main ratings agencies. Clearly, there’s a variety across the globe, but the three largest we tend to rely on are Standard & Poor’s, Moody’s and Fitch. Combined, they have similar notations.

You say AAA down to D or U, with D being a default. U is an interesting one because sometimes that might mean they’ve not been rated by those agencies, but if you’ve got a strong team of analysts, you can actually rate them yourselves internally.

It doesn’t always mean it’s a terrible credit, because there’s quite a lot of companies that choose to be unrated for a variety of reasons.

In terms of what they actually mean and how rating agencies assess this, and we might come up with our own internal ratings, the rating really looks at the probability of default or the creditworthiness score, going back to your GCSE analogy, a score of how creditworthy a company is, and that risk of bankruptcy or default over a certain time period.

Now, depending, that’s somewhere between a year or five years. There’s ways you can translate what the probability of default is over, say, a one-year horizon from an implied credit rating, but typically, it goes up in an exponential way. 

So, when you get down to D, you’re already in a default, but the lowest rungs just above that, in that junk or high-yield area, you there might be 50% to 75% chance of a default over the next year. When you get to AAA, it’s minimal. You’re looking at decimal points. 

In terms of that investment grade, high yield, or sometimes people call it junk, there’s different tiers as you go down. The broad categories, AAA, AA, A, BBB, when you get to the bottom end of BBB, the delineation is BBB- or Baa3 if you’re Moody’s. And that delineates where investment grade ends.

In terms of how a lot of bond fund managers like us manage money, they tend to split risk indices or benchmarks they manage money against into investment grade and high yield, and then combinations thereof depending on what the strategy is looking to do. And then, really, it’s junk or high yield from there. 

But as I say, the probability of default over that time period is going up reasonably exponentially. In terms of how those ratings are built up, ourselves and the rating agencies will look effectively at the operational strength of a company, the industry it’s in, combined with the financial health of that company as well at a point in time on a forward-looking basis.

Kyle Caldwell: And how does the income on offer, the bond yield, feed into those credit ratings? Does a bond with the highest-quality rating, does that mean it’s going to have a lower yield than, say, a bond that’s considered riskier and in the high-yield category?

Damien Hill: Absolutely, generally, that’s correct. I mean, you will get anomalies where certain issuers of governments trade particularly cheap for their particular rating category, and there’s a lot of potential reasons for that in terms of what they might be doing through time, their track record, management, other potential concerns of ESG (environmental, social and governance) or other technical factors. But in general, yes, that’s right. 

Clearly, you’ve got different asset types that command different risk premia or extra yield from investors. So, if you get into the world of emerging markets, for instance, it’s not only thinking about the risk of default and creditworthiness, there are aspects that go into there in terms of things like country risk. Because when you get down into a particular company, you might think it’s brilliant, but you often get a lot more political volatility, certainly historically, in certain emerging markets that you need to take into consideration.

So often, a BBB-rated company might yield quite a considerable amount more in an EM jurisdiction relative to the same rating in an investment-grade developed market.

Kyle Caldwell: So, we’ve covered off the basics. Let’s now move on to two big factors that hugely influence the bond market, interest rates and inflation. Could you explain why they are so influential?

Damien Hill: Yeah. So, if you look at interest rates to start with, and that dovetails with something I said earlier, if rates go up, clearly the return on savings and the cost of borrowing goes up. You can always question with your bank in terms of how much that savings gets transmitted to you as the consumer, but ultimately, if you have a higher interest rate environment, the Bank of England set the base rate, and off the back of that, banks will generally put up the return on savings. 

So, when you think about bonds with those fixed-rate coupons and that fixed payment you get at maturity, the requirement to actually own a bond, again, the required yield to compensate, goes up in general. So, again, the bond price will fall.

Conversely, when interest rates fall, that return on savings, the cost of borrowing falls, and then bonds are worth more because, again, you’re getting a fixed amount of income through time. Clearly, it depends on the type of bond, the type of coupon. But as I say, when it’s fixed, that’s generally the correlation; yield and rates up, price down, and vice versa.

In terms of inflation, when you think about those fixed-rate coupons - if they don’t vary with inflation, and clearly, if they’re fixed rate, they don’t, because you can get bonds called inflation-linked bonds, where the coupons go up or down with inflation rates. But if inflation is up, generally that has a depressing factor on the price because then the compensation, the required yield, will generally go up to compensate for that inflation out in the economy.

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Kyle Caldwell: A key metric that investors can see on a fund factsheet is ‘duration’, which measures the sensitivity of bonds to changes in interest rates. Duration is heavily influenced by the life of a bond, but there’s more that goes into it than that. Could you explain further?

Damien Hill: So, the duration number you see will often be expressed in a number of years and what that means in aggregate for all the bonds in a particular fund or portfolio, that is the weighted average time to cash flows effectively.

So, when you take an individual bond, you do your discounted cash flow analysis, you say, on average, what is the weighted average of the cash flows I’m getting? So, you clearly have your annual amount of income you get, that coupon, getting paid semi-annual, but you might turn it into an annual number and combine it with the maturity payment that you get at the end. And you say, what is the average time to receiving those cash flows?

Clearly, that will shift around a little bit depending on the yield in the market, the return that investors require, but that might be getting a bit too technical, so it can shift a little bit up or down.

But generally, it doesn’t shift a huge amount with that, but that’s really the interaction of that income versus the redemption payment. But as you said, what it is, if you’ve got a bond, say, with five years average time to its cash flows, you say, well, if the yield goes up or down by 5% to 1%, then the bond will go up or down by 5%, if that makes sense. Often, we express it in smaller increments than that.

We might say 0.01% and it goes up by point 0.05%, but that’s the gist, that effectively that duration, let’s say, remains fixed for simplicity’s sake, that’s the sensitivity. So, that’s what that number will translate to. Interest rate or yields up a per cent, bond falls by 5% or a fund falls by 5%, and vice versa the other way.

Kyle Caldwell: Let’s move on to the outlook for bonds today. Now, you might tell me otherwise in a moment, but on the surface, it looks like a very good time to be a bond fund manager given the level of yields, the amount of income that you can find in the market, is much higher than it has been for most of the past 15 years.

During that period, interest rates were mainly at rock-bottom levels. At the moment, UK interest rates are 3.75% and UK inflation is running at 2.8% [at the time of recording]. But you can find lots of bond opportunities, both governments and companies, that are yielding above 4%.

Damien Hill: Absolutely. That’s a great characterisation. For a long period, as you say, income and yield were pretty low in the post-great financial crisis era, where there was a lot of quantitative easing from central banks. The UK was, case in point, that happened here as well. 

So, absolutely. You’ve got five-year UK government bonds giving you, say, 4%, 4.5% yield. If nothing happens, that’s the rate of return you would expect to generate annually, as we’ve said from those yield calculations. And on the corporate bonds in the UK and in other jurisdictions hedged back to sterling will give you 5%, 5.5% depending on the creditworthiness in the investment-grade arena.

Clearly, if you then go down to high yield, you can earn more, but then the credit risk goes up, say, 6%-7%, depending on how far you want to go. As a reminder, what bonds are giving you is a contractual income. So, if a company or government does not pay that income, they are in an event of default.

So, for a company that means effectively the equity could be worthless. You rank behind bonds in a bankruptcy scenario. So, there are contractual payments, that income you’re getting through time, and that really is quite compelling at this point, at least as a diversifier, because that income cushions you for further volatility in interest rates.

You have to have quite large back-ups in yields to start losing money on a one-year look forward basis. So, you’ve a positive return asymmetry, higher creditworthiness than what you have in equity markets without the concentration.

And clearly, you can look further beyond the UK. So, in our UK strategies as well, we’re able to look globally and take advantage of opportunities to add performance by that active trading. It’s not just about income harnessing and fixed income. As you said earlier, you can buy and sell bonds for capital gains as well, depending if you do your underlying analysis, you can up your risk or reduce your risk to take advantage of directional moves, you can asset allocate between different parts of the bond market, whether that’s between governments and corporate bonds, or up and down the rating scale, different countries, different currencies. That’s before you start looking at sectors and individual company creditworthiness.

So, there’s a huge amount of levers you can pull to add value, but the bread and butter is there’s a lot more income, a lot more yield, and it’s contractual income. Because remember, companies don’t need to pay dividends.

Kyle Caldwell: In terms of the role that bonds play in a well-diversified portfolio, they are considered to be the defenders, and a popular strategy that has worked very well historically is the so-called 60/40 approach of holding 60% in shares, and 40% in bonds.

However, in 2022, the relationship between shares and bonds broke down. Some commentators have suggested that going forwards, the 60/40 strategy may not be as effective as it has been in the past. However, I’ve also seen other commentators point out that because of the good level of income now on offer in the bond market, that strategy has potentially been reborn.

Where do you sit on this side of the debate?

Damien Hill: Well, it’s kind of glass half-full, glass half-empty, rear-view, forward looking. But absolutely, you really need to think about where we’re going from here and given there’s a lot more income, a lot more yield, if you have been holding a 60/40 and being patient with it, then you wouldn’t shift from that. If anything, you might up your bond allocation depending on your investment goals.

But absolutely, 2022 was a bit of an Armageddon for bond markets and risk in general. Equities weren’t totally immune, they would have fallen at different points through the year as well. But inflation and rampant inflation is not good for bonds, unless you have those inflation-linked bonds. So, clearly, you can allocate to those. But as a simple 60/40, there’s a lot more compelling income, and…ranks higher in a bankruptcy scenario if a company gets into trouble, and it’s contractual, right?

So, yeah, absolutely. On a forward look, there’s a lot of compelling reasons to add more to bonds if you haven’t had any. And if you had a 60/40, I would probably advise to stay with it. What, really, on a go-forward would really get bonds moving relatively is if you have growth start to wane. Clearly, there’s a lot of tailwinds for growth and there has been. We’ve seen a bit of disruption out of the Middle East, but broadly, the impetus has been relatively strong. You’d say more emanating out of the US and emerging markets. The UK has been a bit anaemic growth-wise, kind of that 1% area. But we’re still forecasting at least moderate growth. 

It’s if you do start to see more of a moderation there where bonds can come back into their own and without that pick-up in inflation. So, I think you’ve seen that through time, say, the Covid era in 2020 or back to the great financial crisis, where bonds really can play a part when you’ve got higher yield and you do get a growth shock. It’s very hard to necessarily predict something that comes from left field and shocks you. And if it’s always after the event, you would kick yourself for not having enough bonds.

So, I can see both sides of the debate, but ultimately, at these levels of income and yield, you’re insulated from a lot more market shocks by owning bonds relative to history. And 2022 was a real anomalous event, certainly on the inflation side of things, and you get a lot more compensation now.

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Kyle Caldwell: I wanted to next ask you about UK government bonds as the listener who wrote in asked for some thoughts on UK gilts. For a DIY investor considering buying gilts directly, what would you say are the main considerations?

Damien Hill: Well, I would say think about the actual yield you’re getting because I know there’s been a lot of popularity to own lower coupon or income-delivering gilts relative to high because of the capital gains treatment, and think about whether the tax-efficiency argument holds between the two of them.

Think about transaction costs, holding periods, whether actually it makes sense to be buying these when you could buy broader bond funds that deliver more active returns by taking advantage of all the dislocations through different bond markets, different asset classes that you could be leaving on the table.

But clearly, there is a draw there for that tax-efficiency argument. But I would take into account all those factors because you could be a bit too concentrated as well. You do need to think about concentrations. Clearly, with government bonds themselves, the fiscal direction of a lot of governments in terms of the debt sustainability has been called into question at times.

I think the UK, actually, isn’t in as bad a position as sometimes is written in the press. We have quite a long maturity profile in terms of when the average time that governments need to pay back their bonds. If you compare it to the US, a lot of bonds are coming from maturity, probably double the amount over the next 18 months. So, actually, gilts aren’t bad. But think about those concentrations, think about whether you are leaving anything on the table here.

Think about the transaction cost holding periods and whether it makes sense depending on what you’re buying them for because I think a lot of people are buying for that tax advantage. You’ve got to ask: what is the opportunity cost as well of what I could also be buying?

Kyle Caldwell: Could you run through the outlook for bonds within the fund that you manage? Where are you seeing the best opportunities, and what are the biggest risks facing your strategy?

Damien Hill: At this point in time, if you translate it back to the UK in terms of our forecast for yields in one year’s time, we are expecting moderately lower yields. There’s quite a lot in the price in terms of political risk. Some of that’s come out in recent weeks, and we’ll have to see who ends up in Number 10 and Number 11, etcetera, and the fiscal policy going down the line, but we are expecting a little bit of capital gain, but more of the return should come from income.

So, broad stability in yields, whilst growth holds up, we think corporate bonds will be well supported as well. Then it’s really a game of flexing all the active levers we have to be able to add alpha or outperformance. Whether that’s directional risk, asset allocation between comparing bonds in the UK, in Europe, in the US, and further afield. Then on a sector basis, is there anything we can be doing there? Generally, in sectors, we don’t think there’s enough cyclical risk premium priced in.

You’ve had a consumer which has had to deal with quite a lot of headwinds over a number of years, whether it’s inflation, higher interest rates, and we’re starting to see a few cracks come through in some sectors within cyclicals. You’ve seen some of the reporting forecasting from some of the auto manufacturers, for instance, over the last few weeks and months that are coming under pressure from competition further afield.

We do favour in that sense more traditional bond market sectors, so harder asset sectors that clearly have low obsolescence in an AI world and are probably more immune to some extent from trade-war risks as well. So, thinking here in the UK of things like utilities and even things like social housing, which again, we think work and the relative valuation is relatively compelling versus history.

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Kyle Caldwell: Do you have any final thoughts on the bond market and bonds, and where they sit in a portfolio? What would your elevator pitch be to try and convince a DIY investor to have some exposure to bonds?

Damien Hill: I think it’s really that contractual income and yield now is so compelling versus where it’s been over the last 10 to 15 years. You think about contractual income relative to equities where they don’t necessarily have to pay an income, it’s no contractual obligation. 

And, really, you think about bond markets. They don’t have the same concentrations like you have in equity markets as well, where clearly tech has had a great run. I’m not saying that can’t continue, but the concentration levels that you’ve got in those markets relative to history - and certain other booms we’ve seen - is getting pretty elevated. You might want a bit of extra ballast in your portfolio to possibly present a hedge if that goes wrong and growth starts to go in a negative direction.

Kyle Caldwell: Damien, thanks for your time today and coming on to talk about all things bonds. That’s it for the latest episode of our On The Money podcast. We’d love to hear from listeners. If you’ve got an idea for a future episode or you have a question that you’d like one of the team to tackle, then do email us on: otm@ii.co.uk.

In the meantime, you can find plenty of analysis related to funds, investment trusts and ETFs on the interactive investor website at ii.co.uk. Hopefully, I’ll see you again next Thursday.