Welcome to the Alice in Wonderland world of negative interest rates, a place of unintended consequences where investors buy in the vague hope that someone else will pay an even sillier price than they have at some point in the future.
Nowhere are the topsy-turvy results of the negative interest rate monetary experiment more evident than in the fixed income market, which continues to be distorted by central banks’ move below the zero bound.
Negative-yielding bonds might be keeping borrowing costs on the floor for governments and companies, but investors are paying the price. Just recently, the Fitch credit rating agency reported that almost $10tn of negative yielding government bonds (the bulk from Japan and the eurozone) have cost investors about $24bn annually.
Most concerning is the long-term impact this will have on our retirement and pension pots. Traditional portfolio theory dictates that as we move closer to retirement, we allocate more to fixed income as a “safer, less volatile” way to preserve wealth. But with bond yields in negative territory, we could be eroding our wealth by following this type of “lifestyling”.
That’s not even touching on the challenge low bond yields pose for pension scheme providers. One actuary recently described it as “a slow poisoning of pension systems”.
With the biscuit tin under the bed paying more than many governments will offer you for short-term money, the costs of running final salary or defined benefit pension schemes continue to increase. BHS and Tata Steel are salutary reminders of the high cost that past pension promises can have for a company and its shareholders.
Yet, in an uncertain world, both private and institutional investors continue to pile into the asset class. UK gilts have enjoyed the strongest sales in a year and a half, as investors cast aside worries over Britain’s place in the EU and focus on the worsening global economic picture.
Others are choosing to move towards the riskier end of the fixed income spectrum in the hope of finding decent returns, opting for lower quality or longer-dated bonds. This year, junk bonds have been a surprise outperformer but when boring bonds act like shares on steroids you should proceed with caution.
Bonds with the lowest credit ratings have soared in recent years as companies make the most of low interest rates to borrow heavily — junk bonds are paying high yields to compensate for a lack of quality.
But what if you could find a safe spot in the bond universe and still secure a decent income? Step up, ethical bond funds.
These funds tend to invest in higher-quality investment-grade corporate bonds. The Rathbone Ethical Bond Fund, for example, has aimed to provide a higher income since its launch in 2002. It has a yield target of between 5 and 7 per cent (before fees and taxes). For most of that period the fund has managed to deliver more than 5 per cent. While the yield has at times dropped back to about 4.5 and 4.7 per cent, given the fall in bond yields, the fund is currently yielding a not too shabby 5.2 per cent.
Fund manager Bryn Jones admits that a target of more than 5 per cent is perhaps a bit too aggressive in the current environment. That said, against a backdrop of lower-for-longer interest rates, a safe and steady income of around 5 per cent, paid quarterly, should make most investors sit up and take notice.
The Rule of 72 is a quick way to determine how long it will take to double your cash investment using the power of compound interest. To find the number, you simply have to divide 72 by the rate of interest on offer. Assuming fixed interest of 5 per cent, it will take around 14 and half years to double your money.
This might sound like a long time — but consider that at an interest rate of 0.5 per cent, the rate at which the bank rate has been languishing for seven years now, it would take a staggering 144 years to double your money. The right bond investment seems like a much better idea than cash.
Back to ethical bond funds. The positive and negative ethical screens employed by these types of funds — there are about seven of them in the Investment Association’s corporate bond sector — means you’re investing with a conscience.
Funds such as Rathbone’s and Kames’s Ethical Corporate Bond Fund define some of the funding used by UK government as unethical, including armaments, and therefore hold no exposure to UK gilts. Mr Jones says that as an investment house they’ve been pushing the UK government to issue “green” gilts, money specifically used for renewable energy and the like, but are yet to see this materialise.
While ethical investing has received a bad rap in recent years, with many investors steering clear on the basis that you have to sacrifice performance to invest ethically, this is hardly the case in the ethical bond fund space, with the bulk comfortably beating their sector average. The right fund should give you both an investment and a social return.
Ethical investing is also growing in popularity with the younger, so-called millennial generation, who are more attuned to socially responsible investing, which should bode well for inflows over the long term.
Bonds provide a steady income, experience less volatility than the equity market and offer diversification. They merit a place in any balanced portfolio. But investing at a price you know will guarantee a capital loss if held to maturity makes little sense. Active managers need to earn their stripes, at a time when finding the sweet and the safe spots in the fixed income market matters more than ever.
Maike Currie is an investment director at Fidelity International. The views expressed are personal.
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