Bonds are back, but how attractive is the risk-reward proposition?

THAT bonds are back, as numerous strategists proclaim, is reason to celebrate. Finally, yields have become attractive for higher quality issues, after plumbing very low levels over the past few years.

After all, even for younger investors, fixed income assets are a mainstay for portfolios despite a very poor performance last year.

But the big question is – are bonds’ risk-reward tradeoffs attractive enough given today’s fairly high interest rates for safe alternatives?

Based on various compilations, 12-month Sing dollar fixed deposit (FD) rates range between 3.2 and around 4.1 per cent. Rates for US dollar 12-month time deposits could go as high as 4.55 per cent. The latest six-month Singapore Treasury bill auction fetched a yield of 3.88 per cent, and the current Singapore Savings Bond open for application is quoted at 2.9 per cent over 10 years.

Bond yields, on the other hand, range between 4.3 and just over 5 per cent, based on Bloomberg indices for US investment-grade corporate bonds. Going higher up the risk curve, junk or non-investment grade bonds – specifically CCC-rated issues, yield more than 13 per cent. But most investors are unlikely to be able to stomach the credit risk of junk bonds. Emerging market bonds yield over 7 per cent.

Cash as strategic asset?

Here’s the thing: we’re used to thinking about cash as a rainy-day kitty; you keep enough to tide you over in emergencies, but it’s not exactly a strategic asset for many obvious reasons.

One, even at today’s rates, cash still doesn’t keep up with inflation. Two, FD tenors are short and hence you’d be regularly puzzling over the question of where next to park your money in. Three, there is evidence based on numerous studies of long-term capital market returns that a diversified portfolio resoundingly beats cash returns over time.

For now, I would argue that cash presents a hurdle rate for investments that remains hard to beat. US AA-rated bonds, for example, are quoted at an average yield of 4.3 per cent. Does it make sense to invest in that when you can get 4.55 per cent from a 12-month US dollar FD?

A similar picture holds for Singapore corporate bonds. The S&P Singapore Corporate Bond Index is quoted at a yield to maturity of 4.46 per cent, at a time when you can secure a 12-month FD at about 4 per cent. As for equities, the earnings yield on the S&P 500 as at end-December was about 4.7 per cent.

At current rates, cash still deserves a place in your portfolio; it has desirable qualities: safe, liquid, and easy to deploy when the risk-reward tradeoff becomes more attractive.

Still, there are good reasons to begin to consider some investment into fixed income, balanced or multi-asset funds, to lock in attractive yields for the longer term. One of the most convincing reports on fixed income is by M&G Investments.

In a January report, M&G points out that investment-grade corporate bonds were hit by a combination of wider credit spreads and a higher risk-free rate last year, and yields reached their highest levels in over a decade.

It believes that in the credit segment in particular, investors are well paid to take the risk. Markets, it says, are pricing in much of the bad economic news. At end-2022, credit spreads reflected an implied default rate well in excess, not only of average default rates, but also of the worst default rates.

For example, corporate bonds rated BBB indicated a five-year cumulative default rate of 16.9 per cent, compared with an average default rate of 1.5 per cent, and the worst default rate of 5.1 per cent as at October 2022.

“We believe current valuations reflect an excessively gloomy outlook for default rates, and we have been taking the opportunity to add credit risk across many of our portfolios.’’ But it cautions investors to be selective and favour high-quality issuers in defensive sectors.

Bond funds are an obvious avenue for individuals. For a modest sum, you immediately get access to a diversified portfolio with regular distributions.

Based on Morningstar data, one-year returns up to end-December of global bond funds registered for sale here generated an average peer-group loss of over 12 per cent. This was actually a creditable performance, compared to the Bloomberg Global Aggregate Index loss of 16 per cent in 2022. Morningstar’s peer group average of course masks some steep underperformance of individual funds.

Caveat emptor

However, there are a few things to note about bond funds, as this column has pointed out previously.

One, investors who desire to hold bonds to maturity may be dismayed by steep declines in a bond fund’s net asset value (NAV) which was the case last year. Funds’ NAVs reflect the marked-to-market values of securities in the portfolio. If you buy single bond issues and hold to maturity, your bonds would still have reflected a price loss, but it should not matter if you do not intend to trade the bond. You simply collect coupons and the principal at maturity.

Two, when you receive a distribution from a fund, you need to be aware of the composition of the payout. How much of it was paid from capital and how much from portfolio income?

Ideally, managers should refrain from paying out from capital. As a fund investor, you entrust the fund’s management to a professional who actively trades the portfolio to give you both growth and income. If the distribution you receive is really your own capital, then it arguably defeats the purpose of professional management in the first place. This applies across the board to equity, fixed income and multi-asset or balanced funds.

But it is likely that few investors scrutinise the disclosures; they are happy simply to receive an income even if it’s their own money paid back to them. Total returns have two components – price and income. Income has been shown to be the biggest driver of total returns, particularly for bonds. But to actually realise the total return, that income has to be reinvested at a certain rate.

On their part, managers are also anxious to maintain a promised distribution rate, because they aim to keep the funds marketable and not disappoint investors.

But the practice of dipping into a fund’s capital to make good the indicated income level, particularly if done on a sustained basis, is a disservice to investors. In some funds, based on disclosures from managers, the distribution as at end-2022 was 100 per cent from capital, especially for multi-asset and equity yield funds.

All this is not to argue against investing. Investors do need to take some risk to realise long-term goals. Kudos to those who have stayed the path in their strategic allocations and continued to invest last year. But for now, there’s no shame in keeping a good part of your portfolio in cash, as long as you seek out the highest rates.