Cautious investors have traditionally invested in bonds because these investments are perceived to be far less risky than other types of financial instruments like shares and commodities. Indeed, bonds are financial instruments through which investors lend money to an institution for a known period of time against a known promise of a regular interest payment called the coupon.
As long as the institution borrowing the money is financially sound, the investor has a reasonable possibility of getting his or her investment back on maturity along with interest earned at the stated coupon. Even safer bonds are usually issued by large companies and stable governments. They tend to carry an even lower degree of bankruptcy risk.
However, like any other investment, every bond has a price at which it can be bought or sold on the market. Indeed bondholders often sell their bonds ahead of their respective maturity to lock profits on the value of the investment.
In recent years, bond investors have done tremendously well, particularly in the aftermath of the 2008 financial crisis. In a bid to stimulate economic growth, central banks lowered interest rates to virtually zero per cent with the intention of facilitating borrowing by companies, thereby instigating investment and employment.
In the current record low interest rate scenario, bonds carrying higher interest rates would only be sold at a higher price given their attractiveness. Consequently, one finds Malta Government Bonds carrying an annual coupon rate of 5.2 per cent being offered at a premium of 46 per cent over the value investors will get at maturity in 2031. As interest rates continued to decline, investors were forced to buy bonds with even longer maturities in order to maintain an adequate annual interest rate.
Should interest rates start rising again, the effect on bond prices will be the exact opposite
One major peril in finance, however, relates to investors getting used to a blue-sky scenario and expecting it to remain unchanged. There is a rationale for the decades-long rally in bond prices but there is no reason to believe this will surely last forever. Should interest rates start rising again, the effect on bond prices will be the exact opposite of what happened when rates were being pushed down.
Improving economic prospects and inflation expectations may force central banks to normalise interest rates at a higher level. This is already happening in the US, where the Federal Reserve hiked up interest rates twice since December 2015, and is expected to do the same in 2017. The European Central Bank has already started trimming its bond purchasing programme, hinting that it might be slowly starting a path to interest rate normalisation.
In today’s scenario, traditionally cautious bond investors are exposed to the potential risk emanating from a reversal in the long-term downward trajectory of interest rates. In essence, the primary risk for cautious investors is the substantial exposure they tend to have to so-called ‘safe’ bonds with long maturities and low coupons. What used to be considered as stable investment might prove to become very volatile should the interest rate scenario change.
Excessive exposure to one type of financial instrument goes against the basic principle of diversification, which implies the distribution of capital among different investment vehicles so as to effectively distribute risk. One solution for these investors would be to diversify their investment in a portfolio made up of different assets that are managed in line with their conservative financial profile.
Such portfolios should be invested in a way that risk is maintained within a level that is acceptable to the investor. Contrary to a one-asset investment, portfolio management mitigates risk while targeting a sustainable long-term return on investment.
The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice.
Steve Ellul is a chartered financial analyst, a visiting lecturer at the University of Malta and Unit Head at BOV Asset Management.