Are the bonds in your portfolio doing their job?

Bonds are often used in portfolios to even out risk and provide protection from the whims of the equity market. For a long time, one of the safest places to be within bonds has been US Treasuries. These investments have offered a steadfast way to make modest returns without taking on too much risk.

But earlier this year, there was volatility in the Treasury market for UK investors as the US dollar weakened amid tariff concerns. While Treasuries are ticking along on the domestic side, up 6.2%* on the year in terms of dollars, they are broadly flat in GBP terms.

There is always the option to hedge US Treasury exposure as well, which removes the currency element.

However, on a five-year view, unhedged US Treasury exposure would have been preferable for UK investors because of the overall strengthening US dollar. For UK based investors, the current environment of a less predictable US dollar and a lower US government yield curve may mean that Treasuries struggle to look appealing compared to other types of bonds. For example, although they come along with higher risks, global high yield bonds have returned over 7% this year, hedged to GBP**.

These investments are riskier and taking a closer look at how much opportunity remains in these sectors, as well as remembering the role they play in your portfolio, is crucial.

Is there still opportunity in high yield?

Even though default rates are low across high yield companies, they don’t have the same levels of security as Treasuries. Equally, while high yield bonds have been a fruitful sector, investors need to consider how much room they have left to perform in the current economic cycle.

Remember, the future return profile of bonds operates very differently to equities as, while equities, theoretically, have unlimited growth potential, bonds have limits to their growth potential from both their fixed income payments and their fixed maturity dates.

For example, let’s imagine you bought a high-yield bond worth £100 that is issued with a 10-year maturity horizon, with a coupon of 7%. Every year you would be paid £7, and at the end of the 10 years, you’d also get your initial £100 back. So, you'd earn £70 from the bond (before fees) over its life. In reality however, bonds are bought and sold in the markets everyday, so your rate of return is subject to significant fluctuations over the life of the bond. Additionally, the amount you earn depends on how much you pay for the bond in the first instance. If the bond is out of favour at point of purchase, you'll make more than 7% per year (assuming the company comes good on its repayments). This projected amount that you earn on a bond, or a bond fund, is referred to as the yield to maturity.

Let's say, in the first five years of this bond’s lifespan, the realised yield ends up being closer to 10% each year, which is far outpacing the coupon. If you were investing in equity markets, this strong performance could be very enticing, perhaps indicating strong growth and attractive forward opportunities in the company. But when it comes to bonds, it’s important to remember what the available future, rather than realised, return is. As, if that bond had made a yield of 10% each year for five years, the owner would have earned £50. But because that bond has performed so well, the price is now higher for the next purchaser, and a higher price eats into that potential yield for the new owner.

What this ends up meaning is that in bond markets, there’s less potential for the yield to keep rising after a period of outperformance. So, there’s a good chance that investors looking to benefit from the strong returns that high yield has offered over recent years may have already missed the boat.

What low-risk options remain for portfolios?

For investors that are comfortable on the lower end of the risk spectrum, money market funds may still be an appealing option. Year to date, the sector has averaged a 3.4% return. In the past three years, short term money market funds have averaged a 4.3% return annually, bolstered by high interest rates. But this falls to 1.44% over a 10-year view, due to the ultra-low interest rates in the market in preceding years***.

The performance of these funds is largely dependent on interest rates, which often react to inflation. But for those who are looking for returns higher than interest rates, there are some more creative alternatives.

This could include strategic bond funds, which allow the fund managers flexibility to invest in the parts of the bond market where they see the best opportunities. On AJ Bell’s Favourite fund list, this includes the Artemis Strategic Bond and Waverton Sterling Bond funds.

*Source: FE fundinfo IC BofA 1-10 year US Treasury as of 22 October
**Source: FE fundinfo IA £ high yield sector as of 22 October
***Source: FE fundinfo shore term money market sector average as of 22 October