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Bonds are back: but should you invest?

Rising interest rates and falling inflation have created a positive environment for this type of investment

Duration risk can be one of the main challenges when holding a bond. If you can’t hold your bonds until maturity and have to sell, you may incur a loss. Photograph: iStock

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Fiona Reddan
Tue Apr 30 2024 - 05:00

It’s the largest securities market in the world, worth more than €100 trillion, and yet Irish investors may be more inclined to put their money into equities or property than they are into bonds – debt raised either by governments or by companies.

While it may have been a choppy few years for bonds – not so long ago, investors would have been looking at negative yields, particularly on short-dated bonds, due to the interest rate environment – the outlook has changed.

“Fixed income wasn’t on the radar because rates were so low,” says Colm McDonagh, chief executive of Dublin based Insight Europe, a BNY Mellon-owned fund manager with some €750 billion assets under management globally.

And equities were performing strongly. “Bonds are not particularly attractive when equities are going to the moon,” says McDonagh.

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Today however, 10-year German bunds are yielding about 2.41 per cent, Irish bonds 2.8 per cent and US treasuries 4.27 per cent. And on the corporate side, well-rated issuers are offering about 5 per cent.

So is now the time to reconsider allocating to bonds?

Paul Nicholson, head of investment strategy with Davy Private Clients, thinks it is. Following on from the “reset” in 2022, he says bonds are now “a very attractive opportunity once again”.

Why? The first reason is the very high starting yield level, which “gives you a better risk/return profile”, Nicholson says, adding that if you own a five-year bond today, yielding 4.5 per cent, “they’d have to go closer to 6 per cent over a one year holding period to lose money”.

The investment case is “now very compelling”, agrees McDonagh, adding that we’re currently in a new “golden age” for active bond investors.

“Bonds have the income, return, risk profile and staying power that many are seeking,” he says.

Risks

But could you lose money?

“There is always a chance,” says Nicholson, adding, “but the risk/reward ratio is much more in the investor’s favour now. It wasn’t at the start of 2022, but it is now.”

When buying Government bonds, your main risk is related to the chance of default by the Government issuing the debt or, with corporate bonds, the risk of default by the company. But there are other risks.

Duration risk can be one of the main challenges when holding a bond. If you can’t hold your bonds until maturity and have to sell, you may incur a loss.

For Nicholson, a way to avoid this is to concentrate your selection on shorter-term bonds.

“We think the short-end, out to about three to five years, offers the best reward,” he says, adding that the reason for that is a very flat curve.

If looking at Government bonds, the view is that European bonds are looking more attractive than their US equivalent at the moment, due to ‘stickier’ inflation across the Atlantic

So, it’s more attractive to be at the shorter end as investors will be less susceptible for spikes in inflation.

“With a two- or three-year fund, there is limited downside risk,” agrees McDonagh, “as long as you don’t need the money”.

While duration matching can be useful – Ie matching an investment with a future liability – Nicholson expects there to be better opportunities later on, hence the focus on shorter-term bonds, rather than those maturing in 20 or 30 years. “There will be a better opportunity later on,” he says.

To mitigate against risks, if you avoid the long-end, you’ll be less susceptible to higher interest rates due to higher inflation. And, if you stay in high-quality bonds, you’ll avoid the risks associated with deterioration in the economy.

“Those would be the two main reasons for significant bond losses,” says Nicholson.

If looking at Government bonds, the view is that European bonds are looking more attractive than their US equivalent at the moment, due to “stickier” inflation across the Atlantic, which means less movement on interest rates.

“This makes European bonds more attractive than American bonds at this moment,” says Nicholson.

Active v passive

If allocating to bonds via a fund, another key decision is whether to pay a bit more for an actively managed fund, or lock into a low-cost passive option that will typically track an index.

Passive bond funds have been around some 40 years now but have typically been less popular than their equity counterparts. In recent years however, that popularity has grown. The Financial Times recently reported that passive funds have taken in nearly $2.8 trillion since the beginning of 2007. Active bond funds on the other hand, only took in a net $1 trillion over the same period.

Passive bond funds include options like Vanguard’s Total International fund, which aims to track the Bloomberg Global Aggregate ex-USD Index, and the iShares 1-3 Year Treasury Bond, which is an index composed of US treasury bonds with remaining maturities between one and three years.

Despite the sharp influx into passive however, McDonagh favours an active approach.

“Now is the time to go active in fixed income,” he says. While he notes that the rise of passive investing in the last decade has dramatically reduced the cost of investing in bonds, it has also created significant inefficiencies for active bond investors to exploit “as comparatively less active money has been available to arbitrage away relative or absolute value opportunities”.

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Nicholson agrees, arguing that an active approach may make the most sense.

“There is a lot of value to be added by being positioned in long or short-dated bonds, and on top of that, value to be had by being selective on names,” he says, pointing to corporate bonds, with some companies “perhaps having more leverage on their balance sheets than would be sensible”.

“We’re starting to see some pressure in European high-yield corporate bond issuers,” he says. So, opting for an actively managed fund that may be more expensive, but which has a discerning fund manager, can be worth it.

Taxation

Remember, for Irish resident savers and investors, investment in Irish Government bonds is tax-free. This means you won’t have to pay any capital gains tax (CGT) when you sell, or redeem, a bond. You must however, pay tax on any interest earned at your marginal rate of tax. This may be at a higher rate than the 33 per cent CGT rate, given a higher income tax rate of 40 per cent. It is also higher than Dirt charged on deposits, which is also 33 per cent. If you opt for a bond fund on the other hand, you will pay tax at 41 per cent on gains.

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