Traditionally bonds have been considered something of a fixed income safe haven for investors, a steadying portion of a portfolio that will not produce much in the way of surprises, good or bad. But in today’s environment of creeping inflation and persistent low interest rates, an asset class that used to offer reliable access to income is facing significant challenges.
It is a concern which affects some charities more than others: “The low interest rate environment which has persisted since 2008 has been difficult for those charities that rely on an income stream from their investments to fund operations or grant programs,” says Chris Kavanagh – executive director in the charity investment team, Goldman Sachs Asset Management (GSAM).
Bonds have long formed part of charity portfolios. They generally fall into two broad categories: government debt (also known as sovereign debt or gilts) and corporate debt. In government debt, the investor is effectively lending money over a fixed term to the government of the country issuing the debt, while in corporate bonds the investor lends to a company. Coupons, or interest, on the capital loaned is paid to the investor over that term, and at the end of that period the investor is repaid the initial capital. A bond’s yield is equal to the coupon divided by the price of the bond. Those yields fluctuate as the bond is bought and sold at varying prices on the open market during the course of its term.
So-called investment grade bonds, at the lowest end of the risk spectrum, will pay lower yields, while the bonds with the highest risk of default will pay higher yields. At the time of writing, a UK government 10-year UK gilt has a yield of 1.47%. A 10-year German bund was paying a yield of 0.46% while a Japanese government bond was paying a yield of 0.07%. By comparison, a 10-year US government bond was paying 2.48%.
But even the US bond is not paying enough yield to overcome the current economic challenges faced by investors: “If you adjust for UK inflation, where RPI is at 2.5%, that means you have a negative real return,” says Richard Macey, director of charities at M&G. Indeed, says Macey, inflation is one of the biggest issues charities face when it comes to investment. “Trustees are looking to protect their assets against inflation, which is the real enemy of charities; we are constantly reminding our trustees of that,” he says. “It is the trustees’ responsibility to make sure that they are reviewing the performance of their fund managers against agreed benchmarks, which may be indices, the gilts index, FTSE All Shares, and so on, but the one thing they must never take their eye off is how they are doing against inflation over the long term. Because if you are not beating inflation in terms of the value of your capital base and the income that you are paid, then clearly there will be very serious consequences further down the line.”
With historically low yields and rising inflation eroding returns, then, charities that require income need to find investing strategies that can help them achieve their aims. And according to Marilyn Watson, head of global fundamental fixed income strategy at BlackRock, there are plenty of options. “Although sovereign bond yields are low in most developed markets, or for some countries even negative, the fixed income universe is very broad, diverse and deep. We believe that there are still many opportunities to be found in what is one of the largest asset classes in the world,” says Watson. “Investors who are able to allocate to the global bond space, including emerging markets, corporate bonds and asset backed securities, as well as utilise strategies such as relative value and actively manage duration and risk, can still achieve attractive risk-adjusted returns.”
Watson says that taking advantage of opportunities requires “flexibility, research capabilities and a focus on risk management”. She adds: “We see unconstrained global bond strategies – that can scour the globe for opportunities to help weather volatility, mitigate drawdowns and generate attractive risk-adjusted returns in this fast-paced and changing environment – as important building blocks to help make the most of today’s market environment.”
Certainly, there are higher yields to be had by looking into the wider world of sovereign debt. “There are more attractive yields available even in the government sphere if you look at other government bonds around the world,” says Macey. At the time of writing Portugal’s 10-year bond had yields of more than 4.1%, while Mexico’s 10-year government bond had yields of around 7.5%, for example. But, he adds: “We would emphasise that it is important to understand the underlying fundamentals and the risk factors.”
Shifting emphasis towards corporate bonds is another possible course of action – one which is currently favoured by BlackRock: “… overall, we prefer corporate bonds to government bonds where the higher yield can provide a cushion against rising interest rates while a positive growth momentum and stable fundamentals can compress the risk-premia. We believe security selection will be key, and expect a number of interesting opportunities related to M&A financing in coming months,” says Watson.
But as with sovereign debt, the relationship between yield and risk here is crucial. There is, as they say, no such thing as a free lunch. “You may wish to move into less highly rated corporate bonds, where yields on offer will be higher, but there is a good reason because you are taking a greater degree of risk,” says Macey. “The rule of thumb is that the further you go down the credit quality scale, the more the risk you are taking is associated with the individual companies to which you are lending money, with their abilities to fulfil obligations and pay income and to not default.”
A different tack
In fact, it can be argued that in some cases, charities looking for better income prospects may find that a move towards equities is more appropriate than a focus on higher yielding bonds. “It could be that a greater allocation towards equities and maybe property over bonds is something they need to consider,” says Macey.
It is an approach that has been adopted by many, according to GSAM’s Kavanagh. “The most common investment response to this conundrum has been to have a strong overweight in equities, predominately UK equities, where charities can generate a yield up to 4% per annum,” he says, adding, though, that it does carry its own risks: “This strategy has worked exceptionally well since the financial crisis, however it has left many UK charities heavily exposed to UK equity markets and we caution against this approach, especially in the current environment.”
Crucially, in today’s politically unpredictable and economically uncertain environment, charities looking for income need to ensure they pursue routes that suit their own investment goals. Historically low interest rates may rise, inflation may also creep upwards, and the changeable and erratic political climate may have unforeseen impacts on investments.
In the context of such uncertainty, bonds may still have a role to play. Their reputation as a stabilising element in a portfolio can still hold true, argues Macey: “We think that within a well-diversified portfolio, bond funds still have a valuable role to play, because they allow you to ensure that not all of your assets are exposed to slightly more volatile, riskier assets such as equities. Holding on to some bonds can be an insurance policy to protect you when stock markets get very volatile.”
BlackRocks’ Watson agrees: “While most investment grade bonds may have uninspiring prospects, we emphasise that charities should not completely abandon their bond allocation in search of higher yields. As the last several years have reminded us, investment grade fixed income serves a vital strategic role in the portfolio, due to its ability to hedge against economic crises and deflation, reduce portfolio volatility and generate some income.”
Sandra Haurant is a freelance journalist