DIY Investor Magazine
| August 2017
37
BENEFITS OF HAVING HIGH-GRADE GOVERNMENT BOND ETFS IN YOUR PORTFOLIO
•
Diversification benefits
•
Stability during recession periods
•
Price increase when interest rates fall, inflation lowers and/or home currency
weakens against bond currency
WHAT ARE THE RISKS OF GOVERNMENT
BONDS?
In the current low interest rate environment, many
assume that rates must rise which will cause bond
prices to fall; this will inflict capital losses on bond
investors although they are only temporary for bond
ETFs, because ETFs automatically buy new higher-
yielding bonds that eventually make good the loss
by reinvesting more income into cheaper bonds.
However, interest rates are not guaranteed to rise
just because they’ve hit historical lows, Japan’s
rates have not recovered in over a quarter of a
century. If you don’t believe that can happen here
then you can minimise the risk of rising rates by
investing in a
SHORT-TERM VS. LONG-TERM GOVERNMENT
BOND ETFS
Source: justETF.com; 17/04/2009 - 26/06/2017
A rise in interest rates would at least solve the rock
bottom coupon payments currently offered by
government bonds yield more as rates rise, and
this would enable them to return to their traditional
role as a decent source of income.
Inflation risk
is another issue for government
bonds - the chance that your bond returns don’t
keep pace with inflation. Low yielding bonds are
particularly vulnerable to rapid and unexpected
increases in inflation. Solutions include diversifying
into:
•
Inflation-linked bonds that match
inflation hikes.
•
Commodities that have historically
done well in high-inflation environments.
•
Short-term bond ETFs that rapidly
replace low coupon bonds with higher
yielding versions as interest rates rise.
•
Relying on equities and property holdings
to outpace inflation as they have done
over time.
Credit risk
is another trap for the unwary. This is
the risk that a government defaults on its debt and
fails to pay you back as promised.
You can minimise this by investing in government
bonds of high quality: look on your bond ETF’s fact
sheet for average credit ratings of AA- and above.
The final thing to think about is
.
Government bonds are meant to be a source of
stability but foreign bonds add currency market
volatility into the mix.
This can swing both ways. If the pound drops
5% against the dollar then a US Government
bond fund will appreciate by 5% regardless of
the performance of its underlying asset. Equally,
a strengthening pound will detract from the
performance of overseas assets.
Short-term UK vs. short-term foreign currency government bond ETFs
Source: justETF.com; 17/04/2009 - 26/06/2017
