Hedge your stocks with short-term bonds

AFTER a volatile start to 2014 for equities, with the MSCI world index yesterday down more than 5 per cent year-to-date, investors will understandably be thinking about capital preservation. And while the prospect of monetary tightening in the West will be problematic for fixed-income, a careful selection of bonds could help to dampen portfolio volatility.

“Investors need to remember why they owned bonds in the first place,” says James Norton of Evolve Financial Planners. “It’s about capital preservation and a stable income – they are boring, and that’s how it should be.” But with UK and US interest rates set to rise in the coming years, investors will have to be careful to select the least-exposed options.

Ben Smaje of Kennedy Black Wealth Management says that short-duration (one to five-year), high quality corporate bonds are less sensitive to future rate hikes. And by holding them through a fund, capital is far less exposed to losses on individual bonds. The returns are low compared to equities – the yield-to-maturity of Smaje’s prefered Dimensional Global Short-Dated bond fund is currently just 1.76 per cent – but its components have a low correlation with equities, helping preserve capital in times of panic.

As Rebecca O’Keefe of Interactive Investor points out, retail bonds, issued by companies like John Lewis and Tesco, have been in high demand recently. They often yield more than 5 per cent, but are not covered by the Financial Services Compensation Scheme. “Their underlying price is ultimately affected by their associated credit risk, so if capital preservation is key, they may be too much of a risk.”