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Abu Dhabi, UAESunday 23 September 2018

The obsession with bonds misses the complexity

Nima Abu Wardeh advocates income-bearing assets over bonds or bond funds

Illustration by Gary Clement
Illustration by Gary Clement

We’re hurtling towards a financial wall because the world is increasingly grey.

The demographic evolution in developed countries must be accompanied by a financial revolution if we are to avoid going splat.

What am I on about? It’s the issues surrounding the increasing need for income bearing assets by ageing citizens - set to number 2.1 billion by 2050. You see, the aged population is currently at its highest level in human history. Accompanying it is the increasing need to access money to live. Those lucky enough to have investments need them to pay out, to provide an income as it were and to feel secure in the knowledge that it’s not going to dry up.

This is why baby boomers in the US have been taking money out of stocks and pumping it in bonds for weeks. More than US$20 billion has been withdrawn from stock funds since the middle of June; over US$27bn deposited in US bond funds over the same period of time.

Why? Because we’re told that ownership of bonds is ownership of a stream of future cash payments, and that portfolios should increase bond holding the older we get.

But I don’t get this especially in the current investment climate of low interest rates. Plus it is inherently untrue; there are no guarantees.

Here is a random recommended stock versus bond allocation (meaning I went with the first thing I saw):

• Age 25 to 34: 80 per cent stocks - 20 per cent bonds

* Age 35 to 44: 70 per cent - 30 per cent

* Age 45 to 54: 60 per cent - 40 per cent

* Age 55 to 64: 50 per cent - 50 per cent

We’re seeing this in action with the US baby boomers selling up stocks and buying into bonds as stated above. But there's a flaw - bonds are not a safety net. The percentage allocated to bonds is still at risk because bonds can, and do, lose market value.

I repeat: yes bonds are a core asset class but not a margin of safety. Why? Because, to qualify, financial assets need to provide a) zero volatility, b) principal protection, and c) guaranteed income. This is not 100 per cent applicable to bonds.

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Read more from Nima Abu Wardeh:

Buying experiences, as opposed to buying stuff, doesn't make you happier

How to create the ultimate lazy person's portfolio

The rally against cash might not be in our best interests

Could you live without spending for a year?

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However, in the absence of alternatives, and with the desire to at least counter the risk of your other investments, let’s look at buying bonds versus bond funds.

Individual bonds

You own the bond.

Individual responsibility: you are responsible for researching and monitoring the financial stability of the issuer, determining if the bond price is reasonable and building a portfolio around your need for income, risk tolerance and general diversification.

Income: commitment to pay out a defined amount of income at regular intervals, eg twice a year. This income is generally expressed through the coupon - which in most cases is fixed. The bond’s principal is returned to you when the bonds mature. There is a set maturity date - though some bonds are called before it.

Market risk: If sold before maturity, depending on the price at that time, you can gain or lose money. If held till maturity, not affected by market risk.

Liquidity: you can usually sell a bond on the secondary market. Some bonds are more liquid (trade more frequently) than others. A lack of liquidity can result in price volatility. Liquidity can disappear altogether for indefinite periods.

Diversification: your responsibility to buy bonds from multiple issuers and maturities to achieve diversification.

Credit risk: higher-rated bonds historically have a lower risk of default. It is still a risk.

Cost: a markup or markdown upon purchase or sale.

Bond Funds

You do not own the actual bond.

Individual responsibility: they are professionally managed with no maturity date – bonds are constantly bought and sold.

Income: fluctuating monthly distributions.

Market risk: value affected constantly by market conditions. When shares are redeemed, the sale may result in a capital gain or loss.

Liquidity: you can sell fund shares at any time at the current market value of the fund. Some funds may carry a redemption fee.

Diversification: bond funds invest in many individual securities, providing diversification.

Credit Risk: depends on the quality of the underlying securities in which the fund invest. Provides diversification, which can mitigate credit risk.

Cost: annual expense, which usually includes management and other fees. They may have a sales charge or transaction fee at time of purchase.

A simple way to look at it is the following: When you buy bonds, you have bonds. When you buy into a fund, you don’t own bonds.

It is cheaper to diversify if you’re part of a fund. And there’s more liquidity should you need to sell. You have extra costs.

You have more frequent cash flow from a fund – but you don’t have the pay out at maturity.

Can bonds/ bond funds lose money? Yes. This investment does not protect the money you have accumulated 100 per cent.

Is there a science to the ratio of bonds/bond funds versus other investments? I am sticking my head out and saying no. Is there a need for income bearing assets? Specifically guaranteed income bearing assets. Yes. And it’s going to increase with time. Good luck to us all.

Nima Abu Wardeh is founder of cashyme.com. Share her journey on finding-nima.com

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