A place to squirrel away nuts

The logic of regular savings is to build capital. The logic of building capital is to provide an income. The logic of having an income is to avoid the need of continually saving, turning work into fun. There in a nutshell is our retirement planning lifecycle.

A key traditional component of this cycle is the bond market. Traditionally the bond component is positioned in the less spectacular role of safe haven.

Equities did the growing during an investor's youth, taking volatility into its stride, leaving bonds as a retirement plan's first safe haven, absorbing capital gains as they occurred; the place to squirrel your nuts for the winter of your life.

The fixed income section below contrarily suggests a more spectacular contribution from the safe haven bores, making today an opportune time to clarify two of the bigger areas of bond risk: credit risk and interest rate risk.

A bond is a receipt for a debt. Therein hides the first risk — who is giving the receipt? There are many steps on this ladder. The rung closest to the ground is the one with the least risk and carries the lowest interest rate (or coupon).

This would be the world's most financially stable governments. Ascending the ladder means increasing risk in return for higher coupons.

Ascending further you get financially strong local councils or municipalities, financially strong corporations, emerging market governments, strong corporations, asset-backed debt from companies in trouble, and so on.

The difference between the top and bottom rungs can be around 10 to 12 per cent, clearly different risk propositions.

The rating agents, Moody's and Standard & Poor's, both provide different jargon to distinguish between different risk qualities; the language in the bond ratings box clearly indicating the nature of the risk.

Another effective guide to risk is the coupon. The easiest risk-free money is cash. Interestingly, the dollar cash rates lag behind US inflation whilst European rates are marginally higher than European inflation.

So cash does not improve your purchasing power. The issuers (those providing bonds) therefore need to provide a few more basis points above these cash rates to lure investors out of the easy liquidity of cash which is why the lower rung government issuers are often described as providing an investor's risk-free rate of return.

The results below under fixed income give a reasonable indication of what the bond managers are employing within their portfolio.

We don't really need the fund title to guess that ABN Amro Emerging Market Debt and Ashmore Russian Debt, with results in excess of 20 per cent on a year-to-date basis, have been playing with debt with higher yields.

However, recently it has been possible for fund managers normally nestling in the medium to high-quality end of the table to bring in results at around 10 to 12 per cent YTD even though the current coupons are lower.

Why? Enter the other big influence on bond results: the effect of interest rates on bond performance. To guide us through this maze, the extract from the Fidelity site is a brilliant summary of a potentially confusing story.

The fact is that bonds, even at the lowest rung of the ladder, can lose capital value. Recent capital gains have much to do with falling interest rates.

When governments were issuing coupons at 7 per cent per annum, investors could be reasonably sure of receiving that 7 per cent per annum. and the loan repaid on maturity.

Interest rates fell, and new government bonds were being issued at 6 per cent per annum, 5 per cent per annum, and then 4 per cent per annum.

This was great news for investors holding bonds at 7 per cent per annum purely because the market value or the price of their bond will have risen above the original face value paid. With coupons at, say 4 per cent per annum, as an investor, wouldn't you rather pay a little more for an old coupon at 7 per cent than a new one at 4 per cent?

This would certainly be so if the price increase means that your effective yield is 5 or 6 per cent per annum rather than the 4 per cent yield being offered by new debt.

So capital appreciation has been a major influence on some of the 8 to 12 per cent YTD figures being shown amongst the bond managers within the fixed income section.

Here is the rub — is it possible for the easy capital appreciation pickings of falling interest rates to be sustained? The logic applied above can also be used in reverse. If interest rates rise, the capital value of bonds can fall.

Investors buying new coupons at say 4 per cent during a rising interest rate environment might well see new coupons being issued at 5 per cent, then 6 per cent and so on. This means that in a forced valuation situation, the 4 per cent coupon will need to be valued at an amount lower than the price originally paid.

This all makes the happenings of the next few months very interesting. The tide has been coming in over the last few years for capital valuations on bond funds.

With interest rates stabilising at all time lows, the time to review the reasons for holding bonds is again at hand.

Squirrelling them away for a future income remains a viable choice, but holding on for building capital value is coming close to a sell-by date.

RETIREMENT

Places to put money
Equities did the growing during an investor's youth, taking volatility in its stride, leaving bonds as a retirement plan's first safe haven, absorbing capital gains as they occurred; the place to squirrel away your nuts for the winter of your life.


The author is the managing director of Mondial (Dubai) LLC