Are Bonds Really all that Beautiful?

Bonds are beautiful. That's certainly the message when you look at a recent Reserve Bank list of returns on 11 different types of investments, including New Zealand, Australian and international shares, property, farms, bonds and cash.

Since 1990, bonds had the fifth highest average return of the 11. And on volatility, only cash was less volatile. After taking risk into account, bonds look great.

"New Zealand bonds were an attractive low-risk investment, yielding greater risk-adjusted returns than listed property or any type of shares," says Reserve Bank economist Elizabeth Watson in an article.

What about rental property? At first that seemed better than bonds. But by the time Watson allowed for various types of risk, bonds also beat an investment in a single rental property on a risk-adjusted basis.

Does that mean we should all bail out of shares, property or cash and get into bonds? Not necessarily.

In one sense, bonds are low risk. As long as they are issued by the government or high-quality companies, you can be pretty confident they will make their interest payments and give you your money back at the end of the term.

But in another sense, bonds carry more risk - that their value will fall because interest rates have risen.

Let's say you buy a five-year $10,000 bond issued by Safe Company, paying 5 per cent interest. Three years later, you want to sell the bond two years before maturity. What you will get for it depends on which direction interest rates have moved since the bond was issued.

If another company, Equally Safe Co., is now issuing a new bond, and its interest rate is only 3 per cent, everyone is going to prefer Safe Co.'s 5-per-cent bond. You'll be able to sell the bond for considerably more than $10,000.

On the other hand, if Equally's new bond is paying 7 per cent, nobody will want your Safe bond unless you're willing to sell it for less than $10,000.

The rule: If interest rates are falling, the value of already issued bonds rises. If interest rates are rising, the value of already issued bonds falls.

In recent years, as everyone who invests in bank term deposits knows, interest rates have fallen, so the value of bonds has risen. Hence the strong returns reported by the Reserve Bank.

In an extreme example, in 2008 at the height of the global financial crisis, the return on New Zealand bonds was an extraordinary 17.6 per cent. And again, in 2011, it was 13.77 per cent.

But where to from here? Now that interest on bonds is low by historical standards, there's little room for rates to fall much further, pushing up value. I'm not saying bond interest will rise any time soon. I don't know. All I'm saying is that we can't expect more big interest rate falls to boost returns. But the opposite could happen.

You might argue that if you hold bonds directly, as opposed to in a bond fund, your bonds won't lose value if you keep them to maturity - even if interest rates rise a lot in the meantime. Fair enough. But while you're holding onto those bonds, you're missing out on the much higher rates available in the market.

Whatever way you look at it, it would be unrealistic to expect bonds to continue to perform so well in the near future. High-quality bonds are still a good steady investment, but they're not quite as beautiful as they might seem.

As Watson puts it, "Making forward-looking assumptions based on past returns can be dangerous."