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Bonds are a lot riskier than many investors think

Stocks are risky and bonds are safe – or so the thinking goes. But as Merryn Somerset Webb explains, things are not nearly so simple.

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Stay away from gilts

This week, I want to talk about bonds. Safe, boring bonds. I went on the radio earlier this week to talk about just how safe it is to hold government bonds. My answer, to the mild surprise of the production team, was that it's not very safe at all.

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To see why, you have to keep in mind the key point about the pricing of bonds: when interest rates go down, bond prices go up, and when interest rates go up, bond prices go down. This is one of the very few immutable rules of finance. It just is.

That's why bond prices have gone up most of the time since the early 1980s when interest rates across the West began their long decline to today's verging-on-the-ridiculous levels.

It's also why most market participants now think the bond market is at or around what historians will one day see as its long-term peak; as economies recover and rates start to rise again, bond prices should fall.

And of course, should inflation really take off, and should central bankers be forced into raising interest rates fast and far to contain it, bond prices will not just fall, but collapse.

If you believe that inflation is a given in a fiscally irresponsible democracy that has abandoned any attempt at maintaining sound money, you probably don't want to hold nonindex linkedgovernment bonds.

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But you don't have to wander down any apocalyptic roads to see how you can lose a large amount of money in government bonds at the moment.You don't even have to think that the bond market has hit a long term peak. You only need to recognise that we get mild two-year bear markets in bonds on a pretty regular basis.

Let's look back at the bond bear markets in the UK over the past 25 years or so.

There was one from 1989 to 1990.The yield on a five-year UK gilt rose from 8.65% to 13.59% over the two years, and its price fell from 108.01 to 90.01 giving a nasty capital loss of 16.7%. But the 'coupon' (interest rate) on the bond was 9%, so 18% was paid in income over the two years making the investor even in nominal terms.

There was another bear market between 1993-95. Again the capital losses on the ten-year gilt were nasty 12.6%. But with the coupon at 6.5%, the nominal loss was a mere 2%.

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Next up was 1998-2000. Capital losses on the five-year this time were just over 10%, as yields rose less. But nominal losses, again were lower 2.6%.

Look at these numbers and you can see why there is a general view that bonds are safe. Over the long term (which almost no one can allow themselves to consider to be longer than ten years), they've done brilliantly. And when they have done badly, it has been a matter of a couple of percent here or there.

Now look to today. It's different, because with coupons so low, there is no protection from capital losses. The current five-year gilt comes with a coupon of 1.75 %. It is priced just under its par value.

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Let's say we have another one of those mild bear markets over a couple of years. Let's say you make capital losses of 10%, as in 1998-2000. Your nominal losses will be more 6% than 2%. Lose 20% of your capital and you will be down close to 17% and that's just in a normal bear market.

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Thanks to the fact that interest rates are super low and that (bemusingly) investors no longer seem to demand a premium over inflation from their yield, the cushion is gone.

The point is that if you are holding gilts under the impression that doing so is significantly less risky than holding equities, you might be making a mistake, particularly, I think, if you are coming up to retirement.

Until recently, the retirement date of a UK worker marked a fixed point at which decades of savings efforts were valued. If you retired on July 4 2010 and you were (as most people in defined contribution schemes or in Sipps were) all set to buy an annuity, your pension assets were valued and that value was the price you paid for your annuity.

The most important thing to do, then, was to make sure you didn't suddenly lose a whole pile of capital in the run up to that valuation day.

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So, with an eye to the mild bond bear markets of the past 30 years, most people shifted their assets (or had them shifted) into bonds as they aged. But retirement isn't like that any more.

Now that most of us are more likely to enter into some kind of flexible drawdown (whereby we keep our money invested and draw income and some capital to live on) than to buy an annuity, there is no fixed valuation point.

Even if bonds were likely to protect our capital (which they aren't), there would be very little reason to hold them; the key requirement for capital in the run up to retirement and in retirement now is not that it maintains its nominal value, but that it creates a long-term income that we can live off.

That in turn argues for holding very little in the way of low-yield high-risk government bonds and rather a lot in the way of high yielding shares in quality companies.

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Hopefully these will be run by managers who are interested in developing sustainable businesses that can raise their dividends above inflation every year (good dividends grow, but fixed income is always fixed).

I mentioned some funds that invest in this kind of company here a few weeks ago. However, for those who can't quite wean themselves off bond-like products, who are convinced that interest rates won't rise too much, and who want to diversify a bit, there are few investment trusts that invest more broadly into the fixed income and corporate bond markets.

Take a look at Henderson Diversified Income Trust and the City Merchants High Yield (which also invests in some high-yielding equities).

They both come with risks related to credit and to interest rates but on the plus side, their higher yields do go some way to compensate you for this.

This article was first published in the Financial Times.

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