Traditionally, low risk or risk adverse investors and those that require a regular income have either invested solely in bonds funds or held them as a lion's share within their portfolio.
Over the last year, many retired people who depend on the income payments that they receive from bond funds have seen their high Income and corporate bond funds go down in value by anything up to 10%. This is very severe as many investors are unaware that their capital erosion is greater than the income that they receive from the fund.
The reason for these devastating losses can be blamed on high global inflation. The cost of fuel and food has gone through the roof and it looks set to continue especially in the grains market as the breadbasket of the world is the USA. In the Midwest, they are experiencing excessive flooding due to heavy rainfall and it is expected that this year, 20% less corn will be grown and 15% less soybeans will be harvested.
Secondly, investment sentiment is poor. Merrill Lynch said that its May 2008 monthly poll of 204 fund managers across the world showed that they were cutting back on equities and snubbing bonds due to slowing growth and rising prices. Their view was that global growth and profit expectations were falling just as expectations of higher interest rates were rising because of inflation. Bonds cannot perform in an era of rising interest rates and are likely to continue to lose their value.
Another justification for the diminishing value in bond prices can be attributed to negative real interest rates where inflation is now exceeding the actual interest rate payable on these bonds. In such conditions, the general public prefers not to save and to instead purchase what they need today as it will be more expensive tomorrow. Also, the credit crunch in the USA means rising short term interest rates which are adverse for bond prices.
One solution may be Inflation Index bonds where the principal is linked to inflation and they are often used to protect the capital. The principal will rise in value based on the harmonised index of consumer prices and should hedge the bonds against inflation. The disadvantage of inflation index bonds is that Government price indexes always understate the real rate of inflation as they exclude the rising cost of fuel and food and consequently you may not protect your capital from the real rate of inflation.
In this inflationary environment, I would continue to avoid bonds and instead recommend a portfolio mix of short term cash deposits and selected specific commodity investments.
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Hollingsworth International Financial Services Ltd is licensed by the Malta Financial Services Authority to provide investment services under the Investment Services Act 1994.
