The name is Bond

As clients of Gould Financial Planning will know, we firmly believe that diversification of assets is the best way of helping you achieve your long term goals whilst reducing the impact of volatility insofar as is possible. It is a drum which we have been beating since the firm was founded, and it’s a beat which will only get louder; especially during these unusual and uncertain times for financial markets.

We diversify your assets across six headline asset classes, ranging from the “risk off” realms of cash at the bottom of the risk ladder, to the entirely “risk on” realms of equities at the top of the risk ladder. There are however differently risked rungs on the ladder in between these two extremes, and our Investment Committee meets regularly to ensure that we are managing risk, as well as wealth, in the most appropriate and sensible manner possible.

Differing Risks

If cash represents zero risk and equities represent 100% risk, then other assets such as property, bonds and alternatives may fall anywhere in between and, indeed, the risks may change as the economic landscape evolves. For example, we deem property to have a defensive quality due to its “asset-backed” nature, and we therefore allocate it a 67% growth allocation and a 33% defensive allocation.

One area in which we have held more discussions than any other in recent years is where corporate and sovereign debt is allocated; an area we currently call the “Low Risk” asset class. Because the assets within this space are debt-linked, and there is an obligation upon the borrower to repay at the end of the loan term, we deem there to be a lower risk of complete capital loss than from an asset in this space than within the equity space and hence the name “Low Risk”.

However and as already mentioned the ongoing risks of remaining invested here can and will evolve over time; even if the risk of complete capital loss remains low, the risk of capital depreciation during the term of investment remains very real, and is growing – faster than ever in our opinion.

For this reason we no longer feel we can report to you on funds of this nature, and describe them as being “Low Risk”. With effect from January 1st 2017 therefore, we will be renaming this asset class “Loans & Debt”.

What Has Happened?

Interest rates in the UK and many other parts of the developed World such as the US, Japan and Western Europe remain at record lows. As rates declined so the capital values of bonds increased. However, the converse is also true, and if or when rates eventually start to rise capital values will begin to fall.

If rates were to rise quicker than anticipated then liquidity becomes a concern also; rising rates mean that investors will demand higher yields for the credit risk they are taking, and as the sell-off of existing bonds with lower uncompetitive coupons gathers momentum, so investors run the risk of being stuck with bonds nobody else wishes to buy, paying uncompetitive rates of interest; this in turn will weigh heavily on pricing.

When Will This Happen?

This is difficult to predict. We have seen in the US that rate increases have already been initiated, and the question appears to be how many months will it take for the next increase, rather than how many years. The position in the UK, Japan and Western Europe is less clear; and it is theoretically possible that rates could be cut further and further if Central Bank policy does not bear the type of fruit that policymakers want being picked.

You have already told me this; what is different this time?

Touché; this has been on our agenda constantly for five years or more now, and the question is as difficult to answer today as it was in 2011. What is abundantly clear to us however is this; the risk of downside losses is now far greater than the potential upside rewards for investors holding traditional UK bonds and gilts.

Whilst further rate cuts cannot be ruled out, the interest rate card is becoming tired; investors are being treated with complete contempt and as inflation begins to re-emerge (incidentally, this is likely to mark the return of the index-linked gilt concept within portfolios) this will worsen and the market may well lose faith in Central Bank policy which one would imagine would trigger a change in direction.

Why should I hold anything in this asset class at all?

We should be clear that whilst we feel these markets are becoming increasingly difficult to call, there are still plenty of sectors of the “Loans & Debt” market which we believe can offer good value to investors. Floating rate notes could benefit from rising interest rates, and flexible managers with a global, multi-currency focus have the ability to add value by sourcing opportunities globally, changing their focus on a daily basis and taking short positions to benefit from a wider range of potential outcomes.

Therefore, whilst we believe in Western Europe, the UK, the US and Japan the risk to reward ratio is not generally stacked in investors’ favour, there are still opportunities present across the globe; the critical factor is to be careful with which funds are being included.

Nonetheless, my previous bolded statement still stands – these funds should no longer be considered “Low Risk”. In our view, a higher degree of flexibility with the geographical exposure, the investment grade of the debt issuers, and the complexity of the investment techniques will need to be accepted if growth is to continue being achieved.

So, what next?

We have promoted the concept of floating rate notes higher up our “Loans & Debt” shortlist and have already added new funds which we feel are flexible and confident enough to continue adding value from within this asset class.

Our Investment Committee is also reviewing a range of other investment options which we had previously discounted on the basis that we felt labelling them as “Low Risk” was inappropriate and potentially misleading.

Conclusion

To conclude, we strongly feel that continuing to include an allocation to “Loans & Debt” assets is appropriate for you and those managers with the right tools at their disposal will be able to continue adding value. But, whilst the risk of total capital loss from assets here remains low in our view (and hence we will continue allocating them a 67% defensive quality), the prospect of larger fluctuations in capital value during the lifetime of an investment in this space is far greater now than it has been at any point for a number of years.