Chapter 9

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Traditional Investments

A concise guide to traditional asset classes

‘Price is what you pay. Value is what you get.’

Warren Buffett

Most investments in your portfolio are likely to be traditional investments. The main traditional asset classes include:

1. Equities.
2. Fixed income.
3. Cash.

They are likely to make up the lion’s share of your portfolio. In this chapter we focus on their characteristics and roles in portfolios.

Equities

Equities (shares, stocks) represent partial ownership in the company issuing them. When you own a stock you are the proud owner of part of a business. Through stocks you participate in the business’ growth prospects.

Companies primarily raise capital through issuing either shares (ownership, capital, equity) or bonds (borrowing, liabilities). To raise capital from the public, the company lists (quotes) its shares on the stock exchange through an Initial Public Offering (IPO). Creation of securities is done on the primary market. After the IPO, shares trade on the secondary market between buyers and sellers.¹

Equity returns

‘Stock price movements actually begin to reflect new developments before it is generally recognized that they have taken place.’

Arthur Zeikel

Equity total returns consist of two components:

1. Dividends.
2. Changes in price (capital gains or losses).

Companies can compensate shareholders by paying them cash dividends, coming out of the company’s profits. The two rights of shareholders of common stocks are receiving dividends and voting at shareholders’ meetings. Dividends are not mandatory.² Companies are supposed to pay them only when profitable and their Board of Directors decides to do so.

UK companies normally pay dividends twice a year. The ratio between the dividend and stock price is dividend yield. For example, a company pays a dividend of £0.50 on each of its shares. If the share price is £12.5, the dividend yield is 4%.³ When receiving dividend as a shareholder, you can either use it as income or reinvest it back into your equity holdings.

The second component of equity returns is changes in price (price appreciation). You buy a stock for a certain price. When selling it you either make a profit if its price increased or lose money if its price decreased.

For example, you bought a stock for £10. You received dividends of £0.20 whilst holding it and sold it for £12. Your total return is 22%, made up of 2% dividend yield and 20% price appreciation.^4,5

Equity price reflects the value the market collectively assigns to the company. If the market thinks a company will do well in the future, exceeding expectations, more buyers than sellers of its stock may push its price upwards. If the market thinks the company will not do well and its financial results are disappointing, more sellers than buyers may push its share price downwards.

Whilst the forces of supply and demand set equity price, the forces of fear and greed drive sellers and buyers. Equity prices often reflect stories, perceptions, predictions and speculations about the future. When it looks rosy, optimistic and euphoric buyers push the stock market upwards. When it looks gloomy, pessimistic and panicky sellers push the stock market downwards. Fear can be paralysing. You can leave logic behind when fear drives the market.

Sentiment is an important driver of share price over the short term, whilst fundamentals should drive price over the long term. Buyers and sellers overreact to daily good and bad news, causing share prices to fluctuate. When momentum is positive, more buyers jump on the bandwagon, pushing prices further up. The opposite occurs when momentum is negative, causing prices to overshoot.

Over the long term, however, daily news and noise wash out. Price is linked more closely to the company’s financial conditions and the general economy.

Share price stabilises when it satisfies all buyers and sellers. The so-called equilibrium price clears the market, as everyone gets the price they want – not too low to attract new buyers and not too high to attract new sellers. It is an abstract price as stock prices constantly change.

This is how the stock market works. Numerous buyers and sellers buy and sell securities, moving their prices due to forces of supply and demand. That is economics in a nutshell.⁶

Price and value

Market forces set price. Fair value, in theory, is how much a stock should be worth. However, in practice, value is subjective. Your valuation is what you think a stock is worth, based on your assumptions. Reality is the perception of the seer.

The dividend discount model (DDM) evaluates stocks as the present value of future cash flows (dividends) and eventual selling price (terminal value).⁷

The timing and size of cash flows are uncertain. Investors estimate (guesstimate) cash flows by appraising the company’s future financial fortunes. If a company does well, its dividends may increase; if it does poorly, its dividends may decrease. Each investor may reach a different value due to different assumptions.

Then, investors buy and sell the stock, moving its price. There is only one price, there is only one true value, but each investor may derive a different valuation.

Often, instead of dividends, free cash flows (FCF) to shareholders are used in a discounted cash flow (DCF) model.⁸ FCFs estimate the cash the company generates after spending on maintaining and expanding its operations.⁹

Whilst DDM and DCF models calculate stocks’ intrinsic value, relative valuation compares stock price to peers. The premise is that similar companies should have similar value, unless there are good reasons they should not.

One common relative valuation ratio is price-to-earnings (P/E).¹⁰ For example, if a British company in the oil exploration sector has P/E of 10, whilst the sector’s average is 15, the stock may be undervalued. Its price may converge with the average. The question is: why is the company under-priced? Perhaps its business prospects or management are weak.

If you think value is higher than price, buy the stock. It is, apparently, undervalued. If you think value is lower than price, sell the stock. It is, apparently, overvalued. Luckily, price is more volatile than value, creating investment opportunities.

Whether you gain or lose depends on whether your valuation is correct. Even if your valuation is correct, price might not converge to it since the market disagrees with your valuation or it might be due to changes in the conditions of the company or the economy.

The future commercial fortunes of each company depend on both its performance and that of the overall economy. If the economy grows, the demand for goods and services the company sells increases and it may boost profitability. So its stock price can go up. If the economy slows, the opposite occurs. When buying a stock you make two investments: one in the company and a second in the economy.

The risk associated with a single company is called idiosyncratic risk. By holding a sufficient number of stocks of companies with different businesses, you can remove (diversify away) the risk associated with any individual stock. Typically, you need at least 30 lowly correlated stocks to do so. You are left with market risk (beta risk), which is un-diversifiable (systematic risk). This risk is associated with the overall market. You cannot diversify it by only buying stocks.

UK equities

The UK equity market is represented by two common indices: FTSE 100 and FTSE All Share. FTSE 100 Index is a market-capitalisation index representing the performance of the 100 largest companies traded on the London Stock Exchange (LSE).

Market capitalisation means each stock’s weight in the index is calculated by multiplying the number of outstanding stocks each company issues by the stock price. The FTSE All Share Index represents a larger number of stocks, consisting of some small capitalisation stocks excluded from the FTSE 100 Index.

Global equities

The UK economy is an open economy, including a number of multi-national conglomerates. A large share of British companies’ revenues comes from overseas, both from developed and emerging economies.¹¹ Nevertheless, when investing in equities, it is recommended that you adopt a global approach, including equities from around the world.

The US equity market is by far the leading and most developed worldwide. Over half of the global equity market capitalisation is made of US equities.¹² They comprise thousands of listed companies, some of which are the largest, most well-known companies internationally.

Often, the direction of the US equity market dictates the direction of global equity markets. When the US sneezes the world catches a cold. The question is whether other markets can decouple.

The US equity market has the longest, most reliable history of prices, data and research. The three common indices representing the US equity market are the Dow Jones Industrial Average (DJIA), NASDAQ Composite Index and S&P 500 Index.¹³

Investing in overseas equities is fairly easy. You can buy equity funds and index trackers of stocks in North America, Europe, Japan, Pacific and emerging markets. Including foreign equities expands your investment opportunity set and adds diversification. You can participate in global economic themes, such as China’s swift development over the last two decades (although it has already started a secular slowdown), the rise of India and the recovery of Europe. Mind you, when investing overseas, currency risk can have a big impact on results.

The equity universe is divided between developed and emerging markets. Developed markets include the USA, Western Europe, Japan, the UK, Canada and Australia. Emerging markets include Brazil, Russia, India, China (abbreviated to BRIC), as well as numerous other countries.

Emerging markets offer potentially higher returns with higher risks compared with developed counterparts. Whilst often considered a single block, global emerging markets (GEM) are a heterogeneous group of economies with diverse characteristics. They should at least be divided into three main regions: Asia, Latin America (LATAM) and Europe. Economies that are not emerging yet are termed frontier markets.

A popular index for global developed equities is MSCI World Index. MSCI Emerging Markets Index covers emerging markets. MSCI World All Country Index (MSCI AC World Index or ACWI) includes both developed and emerging markets. MSCI offers regional equity indices (such as MSCI North America, including the USA and Canada, and MSCI Latin America).¹⁴

Sector, style and size

Equities are often categorised not only by regions and geographies, but also by sectors, styles and sizes. Sectors are the industry in which the issuing company operates, including: energy, materials, consumer discretionary, consumer staples, healthcare, financials, information technology, telecommunication services and utilities.¹⁵

Styles include value (stocks whose price is deemed below fair value) and growth (stocks with a potential for growing earnings at above-average rate compared to the market).¹⁶ Sizes include large caps, mid caps and small caps.

Academic research and empirical evidence suggest that over time, value stocks and small cap stocks outperform the general equity market, as well as stocks with positive price momentum (winners are expected to continue winning) and quality stocks.¹⁷ This outperformance, however, is patchy, as these types of stocks can undergo long periods of underperformance.

Had they outperformed all the time, investors would have bought them, pushing their price upwards and eliminating their superior performance. When there is an obvious or risk-free investment opportunity (called arbitrage), investors quickly take advantage of it and it disappears. Nothing good lasts forever.

The characteristics and roles of equities

The roles of equities in portfolios are growth, as well as dividend income. Equities make the bulk of growth assets in most portfolios. Whatever your objectives are, equities are likely to play an important role in your portfolio.

Equities are fairly liquid; in particular, those of large companies operating in developed markets. Small capitalisation stocks and emerging market equity are less liquid, but still more so than many other assets.

Liquidity depends on trading volume. Securities and financial markets that are traded frequently and in large quantities are more liquid as more buyers and sellers interact. Liquidity leads to price discovery. As the number of transactions is larger, more securities exchange hands and prices are determined and published more often.

Most equity markets are efficient. This means numerous buyers and sellers trade them, their prices are published throughout the day and markets and companies are heavily researched.

Equity prices react quickly to news. According to some theories (Efficient Market Hypothesis – EMH, which was developed by Nobel laureate Eugene Fama) equity prices reflect all historic information (weak EMH), instantly reflect all new publicly available information (semi-strong EMH) and perhaps even all private information, including illegal insider trading (strong EMH).

According to EMH, it is challenging, or maybe impossible, to beat equity markets through active security selection, in particular net of fees and transaction costs. If you believe in EMH, avoid active funds.

The random walk theory claims equity prices change following a random walk. Past movements cannot be used to predict the future and active management is fruitless.

In practice, however, equity markets are not completely efficient. One proof is bubbles and crashes, demonstrating inefficiency or at least lapses of inefficiency. Another proof is anomalies, such as January effect (seasonal anomaly where markets tend to rise) and weakness in May (sell in May and go away).

Equity markets do not follow a complete random walk as evidenced by superior performance of momentum and trend following strategies. Whilst, undoubtedly, it is difficult to generate alpha in equity markets, it is possible.¹⁸

The main source of equity returns is the equity risk premium (ERP). ERP is the return equity investors require as compensation for investing in risky equities compared to safe-haven assets, such as government bonds or cash. Historically, ERP has been about 4% or 5% on average above the risk-free cash rate. Therefore, cash +4 or 5% is commonly defined as equity-like returns.

ERP changes over time. When investors demand a higher compensation for taking equity risk, ERP rises. It pushes equity’s price downwards (higher discount rate in present value calculations). Lower price today means higher returns in the future. The opposite occurs when investors are less risk averse, demanding a lower ERP. Higher price today means lower returns in the future.

The three main risk factors of developed equities are developed economic growth, inflation and commodity prices. Commodities are an important input for corporations, as well as output for some.

For emerging market equity, the main risk factors are developed economic growth, emerging market economic growth, inflation, commodity prices and currency exposure.

Emerging economies are heavily dependent on developed ones; hence, their exposure to the developed economic growth factor. Many emerging economies are commodity exporters (Russia, Brazil) or importers (India, China). Their equity markets are greatly affected by commodity prices.¹⁹

Investment principles

Benjamin Graham was an investor and author of the classic books Security Analysis and The Intelligent Investor. Considered the father of security analysis and value investing, he advocated three principles for equity investing.

1. Always invest with a margin of safety. Buy equities with a significant discount to intrinsic value (fair value).
2. Expect volatility and profit from it. When investing in stocks, volatility is part of the deal. Instead of exiting the market when it falls, see it as a buying opportunity. Seek investments that were unfairly punished in a correction and are undervalued relative to potential. Two strategies to mitigate the negative effect of market volatility are dollar-cost averaging and mixing stocks and bonds.
3. Know what kind of investor you are. Are you an active, enterprising investor or a passive, defensive investor? Active investors seriously commit time and energy and actively manage their portfolios. Passive investors use passive index trackers. Are you a speculator or an investor? Investors look at stocks as part of a business and shareholders as owners. Speculators buy expensive pieces of paper.

Value investing is not just looking for bargains. Rather, it is a philosophy of performing in-depth fundamental analysis, pursuing long-term results, limiting risk and resisting crowd psychology.

Many stock pickers follow a philosophy of investing in stocks of good businesses managed by competent management, with potential for sustainable earnings growth (stock price reflects the future, not the past and present) at a reasonable price. Price is the cornerstone of every sound investment decision.

It is relatively easy to invest in equities. You can invest in individual stocks, active funds and index trackers.²⁰ Unless you are an active investor, committed to researching and selecting stocks, go with funds, either active or trackers.

This was an awfully concise summary of the mechanics of equities. Equity investing is a popular, fascinating subject, with countless books and research aiming to explain the behaviour of equity markets, suggesting various trading strategies. If you are interested, there is plenty more to read on this topic.

Fixed income

The fixed income market covers diverse types of debt securities, mostly bonds. Bonds represent loans (IOUs). The bond’s issuer borrows money. Investors in bonds lend money to the issuer. In return, the issuer contractually promises to pay its creditors interest, in the form of coupons, and to repay the loan’s principal when the bond matures.

Bonds are negotiable securities. Lenders trade bonds for a price. Some bonds are publicly traded on exchanges, whilst most are traded only over-the-counter (OTC).²¹ Once again, forces of supply and demand set bonds’ price, based on the issuer’s estimated ability to service the payments due and general economic conditions.

Borrowers include governments, corporations, government agencies, local authorities and supranational organisations (such as the International Monetary Fund – IMF). Therefore, the fixed income market is much bigger than the equity market. The number and variety of bond issuers is large and each one issues several bonds, each with different features, terms and maturities. Conversely, only corporations issue equities and normally every company issues a single type of common stock.

Yield to maturity

Yield to maturity (YTM), or redemption yield, is the discount rate equating the present value of the cash flows of a bond (coupons and principal) with its current price. YTM is the bond’s internal rate of return (IRR).

When holding a bond to maturity without selling it, assuming it does not default, YTM is your realised total return. Higher bond price means lower YTM, whilst lower bond price means higher YTM.

For example, a bond’s price is £1,050. It pays 5% annual coupons on its £1,000 face value (principal) and its maturity is three years. The YTM is 3.22% since when using it as a discount rate in a present value calculation, we get £1,050.²² The bond is traded at premium because its YTM is lower than its interest (coupon) rate and its price is higher than its face value. When buying a bond at a premium, your expected return is lower than its coupon rate.

The same bond’s price is now £950. Its YTM is 6.9%.²³ The bond is traded at discount and its YTM is higher than its interest rate. Your expected total return when holding it to maturity is higher than its coupon rate.

When evaluating the bond’s interest rate, use YTM, not the coupon rate, since YTM considers the bond’s price.²⁴

Yield curve

The yield curve (term structure of interest rates) consists of YTMs of bonds with the same credit quality but different maturities.

For example, in the USA, the yield curve includes the yields of 3-month, 2-year, 5-year, 10-year and 30-year Treasury bonds.²⁵

The yield curve shows the interest rates investors demand for holding bonds with different maturities. It represents the term premium. The steepness of the yield curve is often measured by subtracting a short-maturity yield, such as 2-year yield, from a long-maturity yield, such as 10-year yield.

For example, if 10-year gilt yield is 2.2% and that of 2-year gilt is 0.7%, the steepness of the gilt yield curve is 1.5%.

The government bond curve is used as a reference to price debt instruments, such as mortgage rates, as well as liabilities of DB pension schemes. It is also used to predict changes in economic activity.

Government bonds

National governments issue bonds. The two main sources of money for governments are tax proceeds and borrowing in capital markets via bonds. Governments can also print money, but this causes inflation and devaluation of the currency. Government bonds are called sovereign debt or, colloquially, govies. The government bond market is often called the rates market.

The British Government issues gilts, the US Government issues Treasuries, the German Government issues bunds and the Japanese Government issues Japanese Government Bonds (JGBs).²⁶

Gilt price heavily depends on prevailing interest rates and inflation. The price and YTM of govies are set by supply and demand of bonds. When the economy slows down, the market expects low inflation and central banks to reduce interest rates to reflate the economy. Under these conditions, govies are attractive. Investors buy them, pushing their price up and YTM down. The opposite occurs when the economy expands.

A slowing economy is bad news for equities since corporate earnings are expected to fall as demand for goods and services wanes. The same economic forces have the opposite impact on the price of equities and govies. Equities should strive in economic expansion, whilst govies should strive in economic recession.

This is one reason blending equities and govies can generate a smoother return profile. Equities deliver growth in good times, whilst govies offset some of equities’ negative returns in bad times.

Government bond investors are part of a pessimistic bear camp. They hope for bad economic news since this should benefit their asset class. Equity investors are part of an optimistic bull camp. They hope for good economic news as this should benefit their asset class.

You should be neither a bear nor a bull. Aim to be realistic. Include both assets in your portfolio to benefit from the different roles they play.

The characteristics and roles of government bonds

Government bonds are the main conservative assets in portfolios. Their roles are generating income, hedging liabilities, mitigating downside risk (providing some protection), as well as diversifying equity risk.

Govies should perform well in times of flight to quality. During financial stress investors tend to panic, selling all risk assets, such as equities, to seek safety in high quality, safe-haven assets, such as govies. Investors dump all risk assets indiscriminately, pushing pairwise correlations towards one, causing all risk assets to fall in tandem.

Govies can provide some degree of protection to offset a drop in equity markets during stressful market conditions. To generate enough returns, the govies should have long duration; otherwise, price movements are small. The govies need firepower. Do not bring a knife to a gunfight; bring a bazooka.

For example, if a bond’s duration is 8 years, when yields fall 0.50% during a flight-to-quality episode, the bond returns about 4%. With only 1-year duration, the return is 0.5%. Cash with nil duration cannot generate capital gains.

Govies are liquid. You can use them as a source of liquidity in your portfolio.

Government bond markets are highly efficient. Usually they do not include a large number of securities (narrow breadth) since there is only one issuer in each country (the government). Generating alpha in this market is challenging.

The main tools for fund managers to add value are duration and yield-curve positioning. When expecting rates to rise, hold short-duration bonds, since their price is less sensitive to rising rates. When expecting rates to drop, hold long-duration bonds to benefit from capital gains. Short-duration bonds offer a lower yield (carry) than long-duration bonds.

Yield-curve positioning aims to benefit from changes in the yield curve’s shape. Yields across the curve rarely move in a similar way (parallel shift). The curve’s short end is normally more volatile than the long end. When the difference between long- and short-term rates increases, the yield curve steepens and when the opposite occurs, it flattens.²⁷

Fund managers position portfolios to benefit from expected changes in the curve’s shape. For example, you expect a monetary tightening with short-term rates rising faster than long-term rates. You adopt a barbell strategy of selling short-term bonds and buying long-term bonds. This position should benefit from the change in the spread between yields of short-term and long-term bonds.²⁸

The main source of government bond returns is term premium. Bonds with longer maturities normally offer higher yields as compensation for higher interest rate risk. The yield curve is typically upward sloping. A flat or downwards sloping (inverted) yield curve often implies the market expects low economic growth (perhaps a recession) with low inflation (perhaps deflation).

The two main risk factors of govies are real rate and inflation. They drive the majority of performance.

The common index for UK gilts is FTSE Actuaries UK Conventional Gilts All Stocks Index. Its factsheet is available online and includes the index’s performance, volatility and characteristics, such as redemption yield (YTM), modified duration and top holdings. FTSE Russell offers a series of gilt indices with different maturities.²⁹

Global government bonds

Consider including in your portfolio govies issued by foreign governments, not only the British Government. This enhances diversification, benefiting from different monetary cycles of other countries.³⁰

One lesson from the 2011 European debt crisis and 2015 Greek tragedy is to globally diversify govies. Prices of sovereign debt of supposedly creditworthy developed countries can drop surprisingly and quickly.

However, when investing in foreign bonds, currency exposure can dominate returns. It can even reclassify bonds from conservative to risk assets as their volatility can more than double due to currency movements. Therefore, currency risk of foreign bonds should be hedged back to your base currency (British pound).

Inflation-linked bonds

Inflation-linked bonds, commonly called indexed-linked gilts or informally linkers, have a principal linked to inflation. When inflation rises, the principal’s value rises and, consequently, the coupons, which are a fixed percentage of the principal. Instead of focusing on nominal yield, investors in linkers focus on real yields.

The primary issuers of linkers are governments. All G7 governments, as well as others, use linkers as part of their borrowing programmes. Non-government issuers are fairly rare. In the UK a number of utility companies issue linkers as their pricing structure is statutorily linked to inflation.

For long-term savers, linkers whose maturities match the saver’s time horizon are as close as it gets to a risk-free asset. Cash is not risk-free in this context because of duration mismatch. When the value of long-term liabilities changes due to changes in interest rates or inflation, the value of cash does not change as such. However, the value of duration-matching linkers does.

Breakeven inflation rate is the difference between yields of standard govies and linkers with the same maturity. The breakeven rate observes the market inflation expectations over the bonds’ maturity.

For example, 10-year gilt yield is 4% and that of a 10-year linker is 2%. The market expects an annual inflation rate of about 2% over the next 10 years.³¹ Use the breakeven rate to gauge the market’s expectations of future inflation.³²

If you think inflation is likely to be higher than the breakeven, buy linkers instead of nominal (standard) govies. If you think inflation is likely to be lower than the breakeven, buy govies instead of linkers.

Linkers are conservative assets. Their main roles in portfolios are delivering real income, keeping pace with inflation, hedging liabilities and diversifying equity risk.

Linkers are liquid. Similar to government bonds, the number of securities in the universe is small, as governments issue most linkers. Therefore, alpha opportunities through active management are limited.

The main return sources for linkers are real rates and changes in expected inflation. Since linkers remove inflation risk, they are less risky than govies. Linker’s yields are normally below those of comparable govies (unless deflation is expected). As always, lower risk equals lower expected return.

Linkers’ main risk factor is real rate. Changes in inflation are not a risk.

The common index for UK linkers is Barclays Capital UK Government Inflation-Linked Bond Index. The index’s factsheet is available online. Barclays Capital offers a series of bond indices.³³

Corporate bonds

Companies mainly borrow in capital markets by issuing corporate bonds, so-called credit. Since corporations might go bust, they need to compensate investors by offering a spread over the yield of govies with similar maturity. Corporate bonds are called spread products.

Corporate bond’s YTM is that of an equivalent government bond plus a spread. The spread reflects the ability of the issuing corporation to generate enough cash flows to service its debt.

The higher the creditworthiness of a corporation, the lower the spread it needs to offer to persuade investors to lend it money. Performance of credit is derived from that of the underlying, reference govies and changes in the spread.

When the economy is doing well, spreads tend to narrow due to better chances of corporations paying their debt. Investors demand a lower credit risk premium. The yields of underlying govies, however, can rise in such circumstances. When the economy struggles, the opposite occurs. Spreads tend to widen, whilst the underlying government bond rates can drop.

Corporate bonds’ returns are determined by which of these two opposing forces has the upper hand: narrowing or widening spreads or rising or dropping rates.

Credit shares some qualities with equities. Both depend on the issuing company’s commercial fortunes. If a company is profitable, it can generate cash to pay dividends to shareholders and interest to bondholders. If the company is not profitable, both shareholders and bondholders might suffer.

One difference between shareholders and bondholders is that shareholders participate in the company’s upside as, in theory, the share price can appreciate endlessly. Bond price, however, is capped since the spread of corporate bonds narrows when the company is doing well, but it rarely turns negative.³⁴

Shareholders are more risk seekers than risk-averse bondholders. For example, if a company is in financial distress, shareholders might encourage company’s management to take risky projects to potentially boost depressed equity price. Bondholders, however, would encourage management to use prudence, avoiding risky projects to reduce bankruptcy risk and potential default on bonds.³⁵

Credit rating agencies, such as Moody’s and Standard & Poor’s (S&P), publish credit ratings reflecting their assessment of the ability of issuers to meet their debt obligations.

Investment grade (IG) rating means the issuer is unlikely to default on its debt. Below investment grade means the issuer is speculative – default risk is higher than that of IG issuers.³⁶

A change in credit rating affects bond price and YTM. Deteriorating rating means the bond is riskier, its YTM usually increases and its price drops. Improving rating means the opposite.

Spreads of IG corporate bonds typically range between 1% and over 2.5%, depending on credit rating and economic backdrop.

In stressful economic conditions, default risk increases as more companies might face financial difficulties. During the 2008 crisis, spreads surpassed 5.5% and then narrowed sharply as the economy stabilised. With hindsight, which is a wonderful thing, the depth of the crisis was a once-in-a-lifetime buying opportunity for credit.

The characteristics and roles of corporate bonds

The classification of corporate bonds as conservative or risk asset depends on their credit rating. Investment grade credit is considered conservative, whilst low-rated credit can be considered risk asset.

However, high rating is not a guarantee of no default. For example, in 2008 Lehman Brothers, the US investment bank, infamously went bankrupt, defaulting on its bonds, even with an investment grade rating.

The roles of credit in portfolios are generating income, hedging liabilities and potentially delivering growth when price appreciates. Corporate bonds can produce higher income than comparable govies because of the spread.

Credit’s liquidity depends on market conditions. In the past, banks used to hold an inventory of corporate bonds, providing liquidity. However, after the 2008 crisis, banks have scaled down on their proprietary trading. They do not hold an inventory of corporate bonds as they used to due to stricter regulations and capital requirements. Accordingly, the credit market is not as liquid as it used to be. This means transaction costs of trading corporate bonds are higher than in the past.

The credit market is relatively inefficient compared to the government bond market. It includes many different issuers, issuing different bonds with different features (such as callable bonds and convertible bonds).³⁷ This offers active management ample opportunities to add value.

The tools available for fund managers to add value include selecting duration, issuers, credit rating and bonds with different features and yield curve positioning. This all lends itself to opportunities for alpha generation by active managers. However, since transaction costs are higher than in the past, active management faces headwinds as costs eat into performance.³⁸

The main return source for corporate bonds is credit risk premium. Corporate bonds normally have shorter maturities than those of govies, so the term premium is lower for credit.

Credit’s main risk factors are real term, inflation, credit spread and developed economic growth. The latter is a common risk factor for both equities and credit. This explains why these two asset classes can be highly correlated, in particular at times of stress as during the 2008 crisis.

The common index for UK credit is Markit iBoxx £ Non-Gilts Index or Markit iBoxx £ Corporates Index.³⁹

High yield

Investment grade bonds offer a relatively tight spread over govies. They do not need to offer high compensation to induce investors to buy them. It is a different story, however, for bonds with below IG credit rating, often called speculative, high yield or junk. Such bonds must offer a wide spread to attract investors due to material default risk.

High chances of default can cause volatility of spreads. When financial markets go through stressful periods, such as recessions, vulnerable corporations can default. High yield bond prices can fall significantly during such times, as spreads might widen. When financial markets calm down, spreads can narrow, generating capital gains.

The typical high yield spread over govies is between 2.5% and 4%, depending on credit rating and economic conditions. However, spreads can abruptly reach 10% levels and even over 17% at crises.

In the early 1990s’ recession, the 2000 high-tech bubble burst, the 2008 crisis and the 2011 European sovereign debt crisis, high yield bond yields widened, reflecting fears of defaults. However, following each of these crises, yields narrowed back to ‘normal’ levels. Investors who did not sell their well-diversified high yield holdings usually prevailed.

During periods of low yields, cash offers low returns, as do govies and IG bonds. Investors seeking higher yields flock into riskier assets, such as high yield.

However, high yield is a risk asset, not a conservative one. High yield is more correlated with equities than it is with govies and IG bonds. The volatility of high yield is closer to that of equities than to that of govies and IG bonds. There is a downside to investing in high yield.

The roles of high yield in portfolios are income, growth and diversification with govies and IG credit. High yield is a growth asset of fixed income. It can offer high total returns made of carry and price appreciation. Like every risk asset, its total returns might be negative. High yield can substitute some of the equity allocation as a growth asset, but with a lower downside risk.

The risk factors of high yield are real term, inflation, IG credit spread, high yield spread and developed growth. High yield shares commonalities with the fortunes of the equity market.

The US high yield market is by far the largest and deepest in the world. When investing in this asset class, it is recommended to take a global approach. Investing across the USA, Europe and the UK allows for diversification and choice, offering alpha opportunities for managers.⁴⁰ When investing globally, hedge the currency exposure back to your base currency.

The high yield market is far less efficient than other equity and bond markets, allowing managers to add value through active management.

A common index for the global high yield market is Markit iBoxx Global Developed Markets Liquid High Yield Index.⁴¹ Barclays Capital offers a series of high yield bond indices.⁴²

Emerging market debt

Emerging market debt (EMD) includes bonds issued by the governments of emerging countries and corporations operating in such countries. Since EMD is generally riskier than peers issued in developed economies, it offers higher yields to attract investors.

Many emerging economies are on different monetary cycles compared to developed ones. In 2015, for example, whilst the US Federal Reserve (Fed) was on a moderate tightening cycle of monetary policy, some central banks in emerging economies were on an easing cycle (cutting short-term rates). This provides opportunities for capital gains when developed bonds face potential capital losses, as well as diversification benefits.

EMD is a risk asset, whose price can be volatile. It is not as volatile as it was a number of decades ago, as many emerging economies got inflation under control and defaults of emerging sovereigns are not as common as they used to be. But still, defaults occur and emerging economies can run into financial difficulties, such as Russia in 1998, causing a global financial crisis.

EMD is susceptible to downside risk. During flights to quality investors might dump their EMD, causing a drawdown.

EMD is divided into hard and soft currency. Hard currency is denominated in foreign currencies of developed economics, such as the US dollar. The currency is more stable, but the issuing government cannot print money to pay off its debt.

Soft currency is denominated in local currencies of emerging economies. The currency is more volatile, but governments can print money to pay off debt. Doing so can cause an inflationary spiral, currency devaluation and a drop in EMD’s price.⁴³

EMD’s roles in portfolios are income and growth. EMD can diversify holdings in govies and IG corporate bonds.

The risk factors of EMD are real term, inflation, emerging spread, developed growth and emerging growth.

EMD is a relatively inefficient market, offering fund managers opportunities to add value through active management. Active management is important to manage EMD’s risks.

JP Morgan offers popular EMD indices, such as the JP Morgan Emerging Market Bond Index Plus (EMBI+).⁴⁴

Investing in bonds

Choose from individual bonds, active funds and index trackers.⁴⁵ Since trading individual bonds is not as easy as trading equities, and since many pension and ISA platforms do not offer individual bonds, funds and trackers are the easiest route. Use individual bonds to hedge specific liabilities.

One major difference between bonds and funds is that you can hold individual bonds to maturity, realising the YTM notwithstanding defaults. Funds, however, are priced on a daily basis. Their holdings are marked to market and fund managers tend to trade securities, rather than holding them to maturity.⁴⁶

Consider index trackers for gilts and linkers. For IG credit, use active funds or trackers. High yield and EMD can be accessed through trackers, but active management can enhance returns and manage risks.

You are likely to invest mostly in UK gilts and IG credit. Linkers can be used to hedge inflation, in particular when you expect it to rise above the breakeven rate. High yield and EMD can be included in your portfolio, but they are less common.

Instead of selecting from different types of fixed income, you can use aggregate bond funds, mixing gilts and IG credit. Strategic bond funds allow their managers freedom to select securities from across the fixed income spectrum. Multi-asset credit funds typically invest dynamically across the entire credit universe.⁴⁷

Cash

Cash is king. It is the most liquid asset. At times of financial stress or stagflation, cash does not lose money, as do many other assets.⁴⁸ Whilst considered a risk-free asset, cash can generate negative returns in real terms and it can be a risk asset when considering long-term liabilities.

Cash funds are often called money market funds. The two important cash rates in the UK are the BOE’s base rate and LIBOR. These rates are used as a reference for different financial instruments, variable cash ISAs, bank deposit rates and variable mortgage rates.

In a low-yield environment, cash delivers meagre returns. Savers face challenges since bank deposits deliver low yields, potentially below inflation. Low cash rates are good for borrowers but bad for savers.

Saving for retirement needs investing. Investors seeking yields turn to riskier assets with longer maturities or lower credit quality, as well as to equities. When yields of cash and govies are low, investing becomes more important for securing your financial future.

The role of cash in your portfolio includes stable returns, income and liquidity. When you fear financial markets are heading to a tumble, consider shifting assets into cash. Cash may not generate high returns, but it does not lose money.

However, before selling investments and moving money to cash, remember that timing the market is extremely difficult. With the benefits of a long time horizon it is usually better to stay invested, riding through market falls, rather than trying to get in and out. Getting it wrong can hurt performance, as well as generate avoidable transaction costs by churning the portfolio. Time in the market is usually superior to timing the market.

Summary

• Equities are portfolios’ main risk assets. They deliver dividend income and potential price appreciation.
• You can access equities via individual securities, active funds and index trackers. Unless you are willing to commit efforts to research individual stocks, use funds and trackers.
• IG corporate bonds, high yield bonds and emerging market debt are fixed income investments offering higher yields than those of govies, as well as higher potential total returns and losses.
• Invest in bonds through funds. Use index trackers for gilts and linkers. Consider index trackers or active funds for IG credit. Active funds are recommended for high yield and EMD.
• Cash is the ultimate liquidity source. In a low-yield environment, savers need to invest to generate sufficient long-term, inflation-beating returns.

Notes

¹ The company does not raise additional capital on the secondary market. When you buy a share on the secondary market, the money goes to the seller, not to the company.

² Preferred stocks have higher claim on the company’s assets and dividends than do common stocks. Preferred shares usually have a fixed dividend that must be paid before payment of dividends to holders of common stocks. Preferred stocks do not have voting rights.

³ 4% = £0.50 ÷ £12.50.

⁴ 22% = £0.20 ÷ £10 + £12 ÷ £10 − 1 = 2% + 20%.

⁵ Ex-dividend means the shareholder owning the stock on the ex-dividend date (ex-date) will receive the dividend payment, regardless of who currently owns the stock. When the ex-date is declared, the stock price usually drops by the amount of expected dividend.

⁶ Another source of equity returns is share repurchase or buyback, where companies buy their own stocks from the market. This reduces the number of outstanding stocks, creates demand, signals that the company’s management thinks the stock price is undervalued and can push the stock price upwards. Companies can use cash to buy back stocks instead of paying dividends. When borrowing costs are low, corporations might use debt to buy their own shares.

⁷ PV = Σ[D_t ÷ (1 + r)^t] + TV ÷ (1 + r)^t. According to the Gordon Growth Model PV = D₁ ÷ (r − g) where D₁ is dividend next year, r is required rate of return and g is constant annual dividend growth rate (r > g).

⁸ PV = CF₁ ÷ (1 + r) + CF₂ ÷ (1 + r)² + ... + CF_n(1 + r)ⁿ.

⁹ FCF = EBIT (1 − tax rate) + depreciation & amortisation − change in net working capital − capital expenditure. EBIT is earnings before interest and tax.

¹⁰ P/E divides equity price by earnings per share (EPS). For example, if the price is £10 and EPS is £1, then P/E is 10. Earnings are usually after-tax income. Earnings and the circumstances relating to them indicate whether the business is profitable and successful.

¹¹ Research by Capital Group shows that 77% of the turnover of FTSE 100 is derived from sales overseas. Of the 77%, 30% comes from emerging markets, 19% from the USA, 17% from Europe, 5% from Japan, 4% from the rest of Asia and 2% from Canada.

¹² The largest country weights in the MSCI World Index are the USA 57%, Japan 9%, the UK 8%, France 4%, Switzerland 4%, Canada 4%, Germany 3% and Australia 3%. The weights change over time.

¹³ DJIA is a price-weighted index with stocks of the 30 largest industrial companies in the USA.

¹⁴ Factsheets of MSCI indices are available online. Check www.msci.com.

¹⁵ The largest sector weights in the MSCI World Index are financials 21%, information technology 14%, healthcare 13%, consumer discretionary 13% and industrials 11%. The weights change over time.

¹⁶ Value stocks commonly have high dividend yield, low price-to-book ratio and low price-to-earnings ratio. GARP stands for growth at a reasonable price.

¹⁷ Quality can be defined in many ways. High ratio of gross profits to assets, sustainable earnings momentum, high return on equity (ROE), and low debt-to-equity ratio are some quantitative indicators of quality. Qualitative indicators include market positioning, business model, corporate governance, financial strength and management.

¹⁸ The Adaptive Market Hypothesis (AMH), developed by Andrew Lo, attempts to reconcile EMH and behavioural finance. During periods of regime change, market participants adapt to new rules causing temporary irrational market behaviour.

¹⁹ Often, the global emerging equity market universe is divided across commodity importers or exporters and countries with capital account surplus or deficit.

²⁰ It is also easy to invest in equities through the derivatives market. Listed futures and options are available on individual stocks and indices.

²¹ OTC means the security is not traded on a formal exchange, but rather via a dealer network. Broker-dealers negotiate with one another over computer networks or phone to trade OTC securities. Many debt securities are OTC, traded by investment banks. Bond investors need to speak with the bank that makes the market in the bond to get a quote.

²² £1,050 = £50 ÷ (1 + 3.22%)¹ + £50 ÷ (1 + 3.22%)² + £1,050 ÷ (1 + 3.22%)³.

²³ £950 = £50 ÷ (1 + 6.9%)¹ + £50 ÷ (1 + 6.9%)² + £1,050 ÷ (1 + 6.9%)³.

²⁴ Current yield is the annual coupon rate divided by bond price. It is not YTM and does not reflect the bond’s total return.

²⁵ The current yield curve is available on Bloomberg at www.bloomberg.com. The Financial Times offers a free website with market data, including bond rates at markets.ft.com. The Research Division of the Federal Reserve Bank of St Louis offers plenty of current and historic data on US and international markets at research.stlouisfed.org.

²⁶ The website of the UK Debt Management Office (DMO) at www.dmo.gov.uk includes information and data on gilts, including current rates.

²⁷ In a bear steepener long-term rates rise faster than short-term rates, in a bear flattener short-term rates rise faster than long-term rates, in a bull steepener long-term rates fall faster than short-term rates and in a bull flattener short-term rates fall faster than long-term rates.

²⁸ The positions of this pair trade should be adjusted for durations. Say the duration of short-term bonds is 2 years and that of long-term bonds is 10 years, for every 1% on the long term, you need 5% on the short term to have a similar magnitude of returns.

²⁹ Check www.ftserussell.com.

³⁰ Global bond funds specialising in government bonds are available. Citi WGBI (World Government Bond Index) is a popular index series for global govies. The countries with the largest weights in the index are the USA 33%, Eurozone 32%, Japan 22% and the UK 7%.

³¹ The breakeven rate is affected by additional factors, such as tax treatment of different bonds, supply and demand forces and liquidity premium. Hence, breakeven does not purely reflect inflation expectations.

³² Yields of index-linked gilts and other information on UK linkers are available from the UK Debt Management Office at www.dmo.gov.uk. YTM is called redemption yield at DMO’s website.

³³ Check the website of Barclays Capital dedicated for indices at index.barcap.com.

³⁴ The maximum total return for a bondholder is the interest and capital repayment plus capital gain, which is limited. Rates of govies can turn negatives, as it did for Switzerland and Germany in 2015. When yield is negative, investors are paying the government to keep their money and give it back at maturity. Instead of return on capital it is return of capital.

³⁵ The pecking order dictates that bondholders have priority over shareholders on the company’s assets in case of bankruptcy. Assets might be sold and shareholders will get proceeds only after all debt has been paid off.

³⁶ IG: Aaa to Baa for Moody’s and AAA to BBB for S&P. Below IG: Ba and below for Moody’s and BB and below for S&P.

³⁷ Callable bonds come with a call option for the issuer, which can redeem or call the bond before its maturity. Convertible bonds come with an option for the investor to convert the bond into the issuer’s equity. Convertible bonds are a hybrid security, lying between equity and fixed income.

³⁸ Due to higher transaction costs, active corporate bond strategies have a higher hurdle to pass. This leads to a proliferation of buy and maintain strategies where trading is minimised.

³⁹ The index’s daily performance is available on markets.ft.com. Information on the index, its characteristics and past performance are available at the websites of ETFs tracking it. Check www.ishares.com/uk.

⁴⁰ The country weights in the global high yield market consist of USA 64%, Italy 8%, Germany 5%, UK 5%, France 4%, Luxembourg 4% and Spain 2%.

⁴¹ Information on the index, its characteristics and past performance are available at the websites of ETFs tracking it.

⁴² Check the website of Barclays Capital dedicated for indices at index.barcap.com.

⁴³ The value of a currency depends on demand and supply. When governments print money, money supply can cause currency devaluation since more of it is available.

⁴⁴ Information on the index, its characteristics and past performance are available at the websites of ETFs tracking it. Check the website of JP Morgan for information on the index at www.jpmorgan.com.

⁴⁵ Listed futures are readily available on government bonds issued by countries like the USA, UK, Germany and Italy.

⁴⁶ The price of a fund is valued based on valuations or most recent prices of its holdings.

⁴⁷ We have not covered large segments of the fixed income market, such as securitised debt (for example, Asset-Backed Securities – ABS, Mortgage-Backed Securities – MBS, and Collateralised Loan Obligations – CLOs), Floating Rate Notes (FRNs) and many other types of bonds. Leveraged loans are another fixed income asset class, although it is often considered an alternative investment.

⁴⁸ Stagflation is an economic condition where inflation is high, economic growth is stagnating (slowing down) and unemployment can be high. Central banks are conflicted since lowering rates to reflate the economy can further increase inflation.