Am I taking too much risk in holding bonds in the current low interest rate environment?

NOTE: This post is more than 12 months old, and the information contained within may no longer be accurate.

In building an investment portfolio we consider the level of investment risk that any individual investor is able to take as being critical to the appropriate construction of this portfolio.

Over the longer term we fundamentally believe that equities are likely to give the best return both in terms of capital growth, dividends, or a combination of the two. However, with equities particularly, comes a higher degree of volatility (fluctuation in the underlying values), which is our most common metric that we consider in assessing the risk of the portfolio.

Theoretically speaking, and if people were robots rather than feeling and thinking emotional human beings, individual’s words, and they are equal, have the largest possible exposure to equities that they could based on their age investment horizon

However, this is not realistic or practical, as whilst we educate, prepare, and ultimately counsel people when investment markets experience financial shocks, this is not infallible, and the risk is that individuals ultimately sell out of their investments, or otherwise switching to something else at a time when they should really be staying put.

One of the most, therefore, in constructing a client portfolio is the use of government bonds which is an primary way of mitigating volatility and stabilising returns. Funds themselves are not expected to give a return but act as a full stability.

As interest rates have fallen government bonds have performed exceptionally well, invariably better than most commentators with expected given the generally more cautious nature. Whilst investment bonds whilst government bonds are generally more stable due to the fixed income they provide and government bonds in particular have the backing security of sovereign nations, they become more volatile as interest rates have fallen and the value has risen significantly due to this effect. Whilst bonds prices have tended to be less volatile than shares. And given a smoothing effect the risk increases as interest rates are so low that if interest rates were to rise there could be a significant negative impact on the value of bonds.

This is been a risk for many years, but as the trend in interest rate has continued downwards by performance has been stronger and stronger, but perversely the risk of interest rate rises and the impact on bond values increases.

The last few weeks there have been so off in bonds and capital values have fallen which has raised this concern in the minds of individuals

The reasoning for holding bonds, in my opinion that still continues to be valid, and of course there’s no assurance that interest rates won’t fall into negative territory which means bonds could continue to rise in value.

Not wanting to speculate is a solid reason for not making tactical decisions to avoid bonds, the more basic consideration is that if an individual is concerned over fixed interest securities are looking for alternatives, what alternatives are there

Cash will not be appropriate as it does not typically provide the inverse correlation that bonds do: when investors sell out of equities, they tend to move to yachts, not cash, on the other hand individual collect more equities but this is appropriate for the opposite reason: they’re now taking too much investment risk, which is unlikely to be appropriate for them if the asset allocation has been constructed in a way that seeks to minimise volatility stop

In conclusion I would say the risk of shocks in fixed interest market is greater than it has been for some time, but to make tactical decisions to move away from bonds is to misunderstand their purpose in a well diversified portfolio, and unlikely to be appropriate for most investors given the unique nature of bonds and their historic inverse correlation between equities and bond values

It’s properly worth mentioning I don’t believe in so-called “alternative assets” as these are universally failed to meet up to their intended purpose and tend to come and increase cost and complication that makes them inappropriate, albeit for different reasons.

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