Investing in bonds in an inflationary environment.

With inflation figures reaching worrying levels in the US, UK and Europe, not to mention most emerging markets where they look as though they are getting out of control, this might seem to be an odd time to be looking at bonds as an investment. Index-linked bonds have been popular for some time now because they protect investors from future inflation rises but they don’t offer very compelling value at current price levels. However, fixed rate bonds now look appealing.

It has been difficult to find good value investments for some time, even though stock markets have fallen in recent months. The worst hit sectors of the main stock markets are financials and construction stocks, some of which have gone bust or been rescued by the State, such as Northern Rock and Bear Stearns, and where share prices have fallen over 60% in other cases. It is debatable whether these stocks represent good value because we are probably not near the end of the credit crunch yet, with problems in Europe and the UK still only just starting to unfold, and the property market is going to have to fight a lack of buyer confidence plus a huge oversupply in some areas for several years to come. They are cheap but for a good reason and they could struggle to grow earnings for some time.

An investment in bonds at a time such as this is based on the belief that inflationary expectations are priced into current bond yields and there are many bonds that offer what looks like good value, in a world of rapidly rising prices where value is difficult to find. It is also possible that the recent inflation scare has caused prices to overshoot on the downside.

Bonds also offer good visibility, if we stick with investment grade bonds, as they are rated for security (unlike stocks) and we can usually assume that the capital will be repaid at maturity if the company doesn’t go bust or default on its debts. In the event of a serious problem appearing out of the blue there is also a better chance of getting paid if you are holding bonds compared to shares as you are higher up the list of creditors.

To reduce the risk of default, or its effects on a portfolio, you can:
1) diversify across a number of different bonds
2) stick to investment grade bonds only
3) focus on blue chip companies.

By doing this we reduce the risk of loss from default as much as possible. This provides a great level of security, if we can assume that capital will be repaid at maturity. We can add another level of security to the investment by choosing securities with a short to medium term maturity date such as a minimum of 2 years up to a maximum of 5 years. This means that we could probably hold a bond to maturity if inflation does get out of control and bond prices drop even more sharply from here.

However, current investment grade corporate bond prices provide us with a margin of safety. There has recently been a reversal of interest rate expectations in the US, EU and UK which has seen bond prices fall sharply and yields have moved up to very interesting levels. Many corporate bonds are trading at below par and are offering yields more than 100 basis points above base rates.

Here are some examples:

Bayer AG 2012 €. Yield 5.79%.
Unilever 2012 €. Yield 5.29%.
Gaz de France 2013 €. Yield 5.44%.
Tesco 2010 £. Yield 6.27%.
AT&T 2012 US$. Yield 5.20%.

Since March this year, less than 12 weeks, the Gaz de France bond has seen its yield rise from 4% to 5.44% and the Tesco bond has seen its yield rise from 4.7% to 6.27% over the same period. In my opinion, neither of these companies are likely to default before the bonds reach maturity yet they are now offering very interesting yields above base rates.

A portfolio of investment grade corporate bonds at these prices can boost returns on money that was previously sitting in cash (in very short dated maturities) and could provide a capital return if economic growth slows more rapidly and starts to become the main focus of central banks and their governments once more (in longer dated maturities). If investors feel the chance of this happening is significant then they can also buy much longer dated bonds that will rise more if interest rate expectations weaken. A staggered portfolio will provide the best risk/reward ratio. These bonds should remain fairly liquid and will also have defensive properties if stock markets fall further or if the geo-political situation in the Middle East worsens. If the price is right, bonds can be worth buying in an inflationary environment.