Welcome to the future – I don’t know about you but I never thought we’d get here.

Investing in bonds and understanding the way the bond market works, is not something that comes natural to me.  I’m conscious that it’s a topic a bit too technical for some – let’s cover some basic ground first, then dip our minds into deeper understanding.

What I understand about investing in bonds so far, is that it’s supposed to give me a better overall qualitative return than if I invested in shares alone (a good return overall, but with less of the ups and downs, or volatility). All I need to do is mix a bit of bonds in with my equities (shares). Recently though, with the significantly higher interest rates we’ve been hit with, the value of the bonds have come down significantly. Instead of providing a nice cross-current to adverse market conditions, it’s adding to the terror. How did we get here I wonder?

I’d like to spell out a few basics first here first, then we’ll get a bit deeper in the weeds. I’d love you to watch or listen to this episode I did with  Greg Fleming, from Salt Funds Management, if this is of interest. Also, for even more of foundational lesson in bonds, Sorted has some fantastic info too.

When you invest in a bond, you’re lending money to a government, local government, or corporates.

The borrower pays the lender (investor in the bond) an interest rate, for an agreed period of time. Then, just like any loan, the principal is eventually repaid – this happens at a point in time called ‘maturity’.

Unlike saving through a term deposit though (which is what you may do, if you want some certainty with your interest income), when you’re investing in bonds, you’re investing in something that can be bought and sold on a market after it’s issued. In a rising interest rate environment, like right now, bond values to drop. On the other side, falling rates cause bond values to rise (as investors are willing to pay a premium to get a better interest rate). We’ve seen since the early 80’s, bond values steadily increase in value each time there was surge in lower interest rates. In a normal situation, when your shares drop in value (say there’s a recession too), interest rates fall. Bond values go up, providing a nice wee consolation prize to equity holders. Most managed funds have an allocation towards fixed interest or bonds. You may be investing in around 40% bonds if you have a balanced KiwiSaver as an example. The reason why bonds have historically been great to invest alongside shares, is more technically known as negative correlation within a portfolio (or collection of investments).

Shall we go deeper?

I don’t know why we’re prone to confuse theory for law, but we do.

Every now and then, dynamic reality slaps us around until we get it. Pick an investment strategy yes, but stay agnostic – don’t get too precious about your investment community, style, or philosophy. Remember it’s what you’re trying to build that’s important, not just how you go about doing it.

I think the real risk with investing at the moment, is that we could get caught off guard the more we become welded to any framework. The 4% rule, the rule of 72, the efficient market hypothesis and the… brother of a cousin of another mother, the efficient frontier. It’s great to understand these concepts but we have to remember there was a time before these concepts were even noticed – most likely it was a time of change too [kind of like what we have now].

I think it’s at least a theory, but it could even be mere speculation that we’re already in a new regime on multiple fronts. Of interest today, is that bonds don’t provide the same value in a balanced portfolio.

And this is where you have to spot a pattern: A lot of things may not work quite the way they would have in the past. On the bright side, the everyday investor keen to push forward with a bit more macro-economic understanding doesn’t need to have a degree to figure it out.

Those without a formal education may have a higher chance in getting to know the financial system for what it is. The rest of us have some re-learning to do.

Central Banks and (*cough cough) Government, have created so many distortions with their interventions, that stress cracks are now starting to form. Personally, I can’t believe how things haven’t broken already (pension funds, repo markets, a dominant US Dollar, and the collapse of the Euro to name a just few areas). Then again, perhaps it’s always been broken and held together with ‘patches’. As long as there’s a road to kick the can down, that’s exactly what happens. Maybe this is why the financial system will likely survive just fine? It’s not checkmate yet.

Both shares, and bonds have been declining at the same time though. And that’s not supposed to happen.

Having said that, it’s not like we shouldn’t have seen this coming.

A brief history? Go on!

It all started to get odd back in 2001, when the US Fed deviated from a what I believe is known as the Taylor Rule. when they allowed interest rates to stay low, for too long (ultimately throwing fuel on the global financial crisis. There was often a bias towards easy money since then in each crisis that would follow. Up until 2008, it also became less clear what traditional free market signals meant – complexity got really really complex. We then figured out the US Federal Reserve would always put us right (pun intended) and effectively do what it took to achieve at least the amount of inflation it was permitted to ‘endure’. As investors, there was was genuinely no need to consider the natural forces outside our control. There’s a strong chance the case for passive investment strategies will carry more uncertainty.

Going further, I’d suggest there’s a strong chance we’ll see quantitative easing continue in every area where Government expands, targeting infrastructure projects the free market would never touch on it’s (green energy transformation anyone?). For the rest of us?  Perhaps even higher interest rates to mop up the mess. How is this not taxation through the financial system?

As we know, all boats float higher on a rising tide… of cheap, new credit.

If this time it is different though with bonds and equities being highly correlated, then the implications are pretty massive. I’m relatively early on in my journey into how all the pieces of this puzzle fit together mind you. This question disturbs me as an investor, and as a property investor though: Has the idea of investing 40-50% of a portfolio into bonds or fixed interest, suffered a terminal illness?

Or, is this a temporary blip in an otherwise long-term trend towards a zero interest rates and infinite bond valuations?

*For a fun game, read it again but substitute the word ‘bond’ for house prices.