Bonds are a tricky area for investors right now. They're normally seen a low-risk way to diversify your portfolio, but in a world where 'quantitative tightening' is set to become the norm, the downside risk is much higher than usual.
Not only are central banks starting to sell bond holdings acquired during quantitative easing, interest rates and bond yields are also gradually rising from their record low levels. That means lower bond prices and potential losses for investors.
Given the high valuations since 2009, I've pretty much avoided bonds for all that period. And I shall probably continue with that approach until bond yields have risen a fair bit of further. As I'm investing with a 15-year time horizon, I should be able to ride out the greater volatility and risk that comes with equities. The longer your time horizon, the lower the risk.
If you want to invest in bonds
But if you decide you do want to invest in bonds - especially corporate bonds - then a recent note from Deutsche Bank makes some interesting points.
Firstly, the bond market is dominated by the US dollar. Global investment grade corporate bonds are now worth around eight billion dollars of which five billion are denominated in dollar. (Investment grade bonds are bonds issued by companies with healthy balance sheets that are unlikely to go bust.) The dollar's dominance is similar when it comes to junk bonds too. This means that if you're considering investing in global bonds, perhaps via an ETF, you're at least partly making an investment in the dollar.
Secondly, because the US dollar bond market is so large, you need a framework to select the most attractive parts of the market. These are normally specific indices that can then be tracked by an ETF. Deutsche outlines five parameters that can give you that framework:
Sensitivity to interest rates:
Normally you look at duration to establish this - not the same thing as maturity. Duration is a measure of the price sensitivity of a bond, which is measured in years. A bond with a longer maturity would normally have a higher duration as well.
Investors also need to consider the risk of default and fluctuations in the credit spread as well - in other words, the relative risk of default compared to other bonds.
This is about whether investors are being fairly compensated for the risk they're taking investing in a particular bond or bond index.
If you're going to invest in a particular bond index, valuation isn't the only issue to consider. The index needs to be reasonably liquid - investors must be able to get in and out without moving the price dramatically.
Contribution to diversification:
if you already have substantial investments in US dollar bonds, you need to consider how any further investment in bonds truly diversifies your portfolio. You need to figure out how well correlated a particular bond index is with the wider US bond market.
Looking at the current market, Deutsche thinks that emerging market bond indices provide good risk diversification for a portfolio and that's all the more the case for high yield corporate bonds. The bank also says that no asset class in the US dollar bond segment is heavily undervalued although emerging market bonds (denominated in dollars) and 'yield plus' indices based on carry strategies off the best value.
If you want to find out more about investing in corporate bonds, read this article.