Such funds have four drawbacks.
One is their fees. For some funds, the annual management charge is 1 per cent a year. This is a hefty chunk, for an asset that should have low expected returns. And remember - annual fees compound nastily, which makes high-charging funds especially unattractive to the longer-term investor.
Another problem is volatility. Since 1986 the annualised volatility of monthly returns on conventional gilts has been 6.7 percentage points. This implies that if you expect a 2 per cent annual return - roughly what we'll get if prices don't change - then you should believe there’s roughly a 15 per cent chance of losing 5 per cent or more over a 12-month period.
The third problem is cyclical risk. If the global economy continues to recover, bond funds would probably fall as investors switch out of safer assets into riskier ones. This process might be exacerbated by expectations that the Fed will cease quantitative easing.
In this context, bond funds are especially unsuitable for investors with big floating rate debt, such as mortgages on buy-to-let investments. This is because circumstances in which your borrowing costs rise - strength in the economy causing rising interest rates - should also be circumstances in which bonds do badly.
Fourthly, there are long-run dangers to bonds. An eventual rebalancing of the Chinese economy towards consumer spending would reduce the global savings glut that has forced bond prices up this century, while big long-run government borrowing in the US could also depress prices.
These problems could all be avoided by holding gilts not through funds but directly. In holding a bond to maturity you are locking in a guaranteed return (albeit a low one), and avoiding high charges.
You might therefore wonder whether anyone should own bond funds. Some people should, as they do have a use.
One of these uses is that they help protect us from short-term equity falls. Since 2000 there’s been a significant negative correlation (minus 0.26) between monthly returns on gilts and the All-Share index. This suggests there’s a better than 50-50 chance of bond funds rising in bad months for shares, which should cushion your losses.
This, though, isn’t an overwhelming case for such funds. For one thing, it’s not obvious that longer-term investors should worry about short-term falls. And for these, the better protection against long-run losses might be a direct holding of gilts, which guarantees your wealth on a specific future date. And for another, there’s correlation risk - the danger that gilts and equities will become positively correlated, which would mean gilts lose their hedging power. The fact that the two assets often moved in the same direction in the 80s and 90s warns us not to take a negative correlation for granted.
There are, however, two other types of people who might have a use for bond funds. To see them, remember that we cannot foresee the economic future and so there is a risk that our current optimism will be reversed by a nasty surprise. If this happens, it’s likely that gilt prices will rise as investors try to switch out of equities.
In this event, two particular groups will suffer.
The first are those who are planning to buy an annuity. They would face lower annuity rates as gilt yields fall and hence lower retirement income.
The other group are those who are vulnerable to cyclical risk - those who’ll suffer especially if growth slows. This group includes people who own businesses which are sensitive to macroeconomic conditions; people in insecure jobs; and holders of smaller cyclical stocks.
What these groups need are assets which rise in price in bad economic times. And bond funds offer just this prospect. They are the nearest thing we have to the GDP-linked securities which Yale University’s Robert Shiller has advocated as a means of insuring us against cyclical downturns.
Sure, such bad times seem unlikely in the near future - which is precisely why gilt prices have fallen in the last few months. But it is unwise to invest solely on the basis of what seems likely. We must also consider the small chance of what - for some people - would be a nasty loss. And doing so shows us that bond funds aren’t entirely useless.
