This strategy could help to protect you from a bond market crash

The bond bubble just won’t burst.

Bond prices have been unusually high for at least seven years now. That’s left many people – including some of us here – scratching their heads. How can bond yields possibly stay so low for so long? Surely this must be a bubble?

Last summer, it looked as though the bubble was finally bursting. But then prices reversed and started to rise once again. I’m in no doubt that bond prices will eventually fall, but I’m much less certain about when that fall will happen. It could be a while.

Given that background, does it make sense to invest in bonds? And is there any way to reduce the risk, given that a crash seems likely to come sooner or later?

Why ‘low-risk’ bonds are riskier than you might think

Traditionally, bonds, and especially government bonds, have been seen as low-risk investments. The risk of default on government bonds has been seen as very low, and bonds aren’t normally as volatile as shares.

So if you’re looking for a secure, reliable income, bonds have often been seen as a very good bet. That’s why UK pension funds and annuity providers have tended to own large amounts of UK government bonds – gilts.

(Just a quick reminder – bonds are IOUs from a government or company. These IOUs promise to pay you a certain amount each year, and to repay the original debt on a specific date in the future. A £100 bond that promises to pay £5 a year would start with a yield of 5%. But assuming this was a relatively ‘safe’ bond, then investors would be willing to pay more than £100 for the bond, because a 5% yield would be very high in the current environment. As the price paid for the bond goes up, the yield goes down).

Because both interest rates and inflation are low at the moment, yields on bonds have fallen sharply. But as yields have fallen and prices have risen, the risk has risen too – because a crash may come.

That risk became more obvious last year when bond prices began to fall. The main driver for falling bond prices in 2013 was the infamous ‘taper’. The US Federal Reserve, under Ben Bernanke, made it known that it would start to reduce the amount of money it was printing every month to buy bonds.

With the biggest buyer in the market threatening to cut back on its purchases, it’s not really a surprise that bond prices started to fall.

But that doesn’t explain what has happened to bond prices this year. After all, the Fed’s new boss, Janet Yellen, has made it clear that the ‘taper’ is on track. The Fed has cut its spending on quantitative easing (QE) several times this year.

I think the change we’ve seen is down to the rising awareness that the eurozone is still pretty frail and that deflation is a risk, or if not deflation, a continuing low level of inflation. On top of that, the European Central Bank boss, Mario Draghi, is now committed to pursuing more aggressive monetary policies – that includes bond purchases.

And don’t forget, the Bank of Japan is continuing to print money in large quantities and all this extra liquidity has to find a home. Some of the money will stay in Japan, but inevitably some of it will be spent on bonds in both the US and UK.

Reducing the risk of investing in bonds

Having said all this, I can see why many people would still want some exposure to bonds in their portfolio. Diversification (not having all your eggs in one basket) is important. And timing the market is tricky. After all, people have been calling for a bond crash for years, and it hasn’t happened yet.

So if you’d like to invest in bonds in a reasonably low-risk way, one option is a ‘bond ladder’. Here’s how it works.

Instead of investing in just one bond issue, or indeed in a bond fund, you invest across a range of different bonds with different maturities.

So if you wanted to invest in gilts, you could, for example, buy gilts with five different maturity dates as follows: 2016, 2018, 2020, 2022, and 2024. Then when your 2016 gilts mature, you can reinvest the money into gilts that will mature in 2026. You’ll repeat the process in 2018 – except this time you’ll reinvest in gilts that mature in 2028.

Why is this a good strategy? Because if a bond crash happens in 2016 (ie prices fall and yields rise), you’ll have at least some money to invest at the new, higher yields.  And you can get more exposure to higher yields in 2018 and in the ensuing years.

That makes far more sense than piling all your money into one gilt issue now in 2014 that won’t mature until 2024. If you just invest into one issue, all your money will be locked into one low yield for the next decade. Or alternatively, you’ll have to sell some or all of your gilts at a capital loss.

The other advantage of the bond ladder is that you can easily access a portion of your cash every two years, when the oldest bond matures.

On the downside, the bond ladder strategy probably won’t be that cheap. You can often get hit by quite high bid-offer spreads when you invest in gilts.

It’s also worth noting that if you’re investing in gilts over a ten-year period, you might consider upping your exposure to equities. That’s because over most ten-year periods equities normally outperform bonds. That’s not always the case, and it hasn’t been the case in some recent ten-year periods. But when bonds look expensive, as they do now, the chances of bonds outperforming equities over ten years must surely be on the low side.

So my advice is: consider increasing your exposure to equities, and once you’ve done that, if you still want to be invested in bonds, go for a bond ladder. And for more on building a diversified portfolio that should suit most long-term investor’s needs, you should really take a look at my colleague Phil Oakley’s Lifetime Wealth newsletter. Among many other things, Phil talks more about the benefits of diversification and why bonds form a useful part of a portfolio. You can find out more here.

• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.

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