(Bloomberg Opinion) — If you’re investing in bond funds for your pension, you’re probably doing it wrong. Don’t have to take my word for it; just consider the Bank of England. The Bank’s travails have highlighted the perils of bond investing, not just for personal investors, but also for the professionals.
Bond yields have risen sharply since MPC members revealed a three-way split on February 1st. Two voted for tighter policy, one to ease and the rest for interest rates to remain unchanged.
Yet UK lawmakers are concerned about losses arising from the Bank selling some of the government bonds it accumulated during repeated episodes of quantitative easing since the 2008 financial crisis. The Treasury Select Committee, with its hearing on the topic Tuesday, estimates the lifetime cost to taxpayers of the Bank’s QE program to be £80 billion ($101 billion).
The problem is that the low risk associated with investing in high-quality government debt only applies in the very specific circumstance of you holding your bonds to maturity. Only then do you benefit from their fixed value at redemption. If you sell before maturity, or worse still, if you’re a distressed seller, the losses can be huge, as the Bank’s current predicament demonstrates.
Moreover, this risk is heightened at turning points in the interest rate cycle which we are approaching, when stocks and bonds are apt to become highly correlated, thus depriving investors of the other valuable property of bonds: portfolio diversification. In 2022, bond yields soared as central banks tightened policy, driving stock prices down sharply in the process. Late last year, the tables were turned with both stocks and bonds rallying in unison on (currently unfounded) optimism of rate cuts this year.
In a professional portfolio, the key role of bonds is usually to match assets with liabilities. Defined benefit pension funds understand this better than most, but even they get things wrong on occasion. The near collapse of the gilt market in 2022 was an example of institutional investors doing bonds wrong. Some pension funds attempted to reduce hedging costs by leveraging their holdings of bonds. As the market collapsed, however, they were forced to sell their assets far below face value, wiping as much as £425 billion off pension fund values. This was offset to a degree as rising bond yields also reduced the size of the funds’ pension liabilities. Nevertheless, the disruption nearly destroyed the gilt market and added greatly to the Bank of England’s QE woes.
Notwithstanding these issues, asset managers have significantly increased their exposure to the bond market over the past 20 years, while reducing their holdings of equities, much to the chagrin of personal investors who look to equities to boost their pension pots. In 2000, health-care retailer Boots held 75% of its pension assets in equities, as was fairly typical at the time. In 2001, however, it sent shockwaves through the pension community when it switched to 100% bonds to precisely match its assets and liabilities. In the process, it reduced its fees and dealing costs from £10 million a year to just £300,000.
This bond strategy has been replicated across the industry to the extent that today final salary pension funds hold just 6% of their assets in UK equities. This is the outflow that politicians have been attempting to reverse by coercing investors back into UK stocks.
Getting back to bonds, personal investors can attempt to emulate the professionals to a degree. For many, though, the principal means of accessing the bond market is via bond funds and ETFs. Unfortunately, this means that they run into precisely the same valuation and volatility problems bedeviling the Bank of England.
The risk of bond funds has been cruelly exposed by a popular strategy recommended by many pension providers, which progressively shifts a saver’s assets from equities into bonds in the six to 10 years before their intended retirement. This so-called lifestyling approach caused many older workers to be switched into bonds just as the market collapsed in 2022. Instead of protecting their savings, this attempt at de-risking resulted in some suffering valuation losses in excess of 30%.
This also has implications for the much-vaunted 60:40 (stocks/bonds) retirement portfolio strategy that was popular before the 2022 bond selloff. While bonds can offer some diversification, they can amplify losses rather than ameliorate them.
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There are ways in which personal investors can make bonds work for, rather than against, them. Many investment platforms allow people to buy individual bonds, making it possible to arrange your affairs so that bonds mature or pay coupons at regular intervals to meet your income requirements in the short term, while cash you don’t require for a decade or more, even if you are already retired, can be invested more productively in the stock market. If you rely upon selling equity or bond funds for your income, you run into a problem called pound-cost ravaging. This occurs when you have to sell more and more units in a weak fund to achieve any given income. This will tend to exacerbate the portfolio impact on retirees of a market sell off.
If all this sounds too much like hard work, a final option is to buy an annuity, where a lump sum purchases a guaranteed income for life. A professional manager will then match their own assets and liabilities to ensure you are paid what is due. The downside is that should you die prematurely, it will be the insurance company that benefits from this asset matching rather than your family. What all this serves to demonstrate is that, if you’re investing for your own retirement, the bond market will find a way of parting you from your cash one way or another.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Stuart Trow is co-host of “Money, Money, Money” on Switch Radio and author of “The Bluffer’s Guide to Economics.” Previously, he was a strategist at the European Bank for Reconstruction and Development.
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