Soaring “margin of safety” in bonds boosts their appeal

Bonds now offer an appealing combination for the long-term investor: higher return potential and lower downside risk.

Thanks to rising bond yields, you can now get a yield of 6.3% on US investment grade corporate bonds. High yield debt is riskier but offers 9.4%. Dollar-denominated emerging market debt, which straddles investment grade and high yield credit ratings, also offers 9.4%. Even US government bonds now yield 5%.

These are among the highest yields seen in the last two decades. Within the last few years they were another world away at rock-bottom levels, as figure 1 shows. Many investors shunned bonds at that time. They would be wise to re-assess that stance.

What is the margin of safety?

Not only do these higher yields raise the return outlook, they also offer deliver something extra which will appeal to many investors: a historically high margin of safety against losses.

Bond prices move inversely with yields so a rise in yields leads to a fall in price. The margin of safety is how much of a rise in yields they can absorb over the next 12 months before investors would lose money.

Investment grade bond yields would have to rise by a further 1.0% to wipe out the current yield and Treasury yields almost as much. High yield bonds can absorb a 2.4% rise and emerging market debt 1.5%. These two asset classes offer similar yields but their prices have different sensitivities to changes in yields, which is why their margins of safety differ.

This assumes a one-year holding period. If yields rise tomorrow then prices will fall immediately. Investors have to remain invested for long enough to reap the benefit of the higher yield. It is also possible that yields could rise by even more. It doesn’t eliminate risk but it does add a larger safety blanket than at any point for years (figure 2).

This elevated buffer should provide some reassurance to long-term investors worried about the risk of further price declines (and whether to catch a falling knife). Both the return outlook and the downside risks have shifted to a more favourable footing.