Bonds or funds. What's the best for me?
Redacción Mapfre
Ismael García Puente, head of investment and funds selector at MAPFRE Gestión Patrimonial
Anyone considering investing in fixed income should analyze a series of key parameters to determine whether the investment is worthwhile or not. Depending on the type of investor you are (more or less skilled), the variables to be studied will vary in number. Nevertheless, there are most likely three characteristics that both professional and retail investors will analyze in detail: the duration, the IRR, and the credit rating of the issue.
We must not confuse the duration with the investment horizon; the former is a financial concept that reflects the asset’s sensitivity to interest rate movements, while the time horizon is set by the investors themselves, who decide how long they are willing to keep their capital invested. Duration is calculated as a weighted average of the time over which we collect coupons and/or principal on the investment and is used as an approximation of how much we stand to lose or gain if interest rates rise by 100 basis points (1%). Thus, an investment in a fixed-income asset that has a longer duration will be more affected by interest rate movements.
In simplified form, the IRR is the annualized return we can expect from the investment by collecting the coupons and repaying the principal, provided that all flows are paid on time and there is no bankruptcy on the part of the issuer. It is precisely the third variable (the credit rating of the issue) that serves as a gauge of the issuer’s susceptibility to encountering difficulties in meeting coupon payments and repaying the principal amount associated with the fixed-income instrument. This rating is awarded by specialized companies which perform a series of analyses to assign the issuer one rating or another.
Putting theory into practice, an investment in an asset with a duration of thirty days, an IRR of 4%, and an AAA rating (the highest possible credit rating) should be the preferred choice over another asset with a duration of 12 months, an IRR of 3.7%, and a credit rating of A (a good credit rating, but two notches lower than AAA). However, as often happens, theory differs from practice: with data at the end of June, the first option accumulated “only” net inflows of €1.6 billion so far this year, while the second option has attracted flows of €15 billion. One might think that such a “commercial” success could only come from a unique, novel asset accompanied by a first-class marketing campaign, but nothing could be further from the truth.
Spanish Treasury bills are undoubtedly the investment of choice for Spaniards in 2023, making them the largest holders of this instrument. In fact, one out of every four euros issued is already in the hands of individuals, according to data from the Bank of Spain. The sharp and rapid rise in interest rates by the European Central Bank (ECB) to bring inflation back to 2% has revived the appetite for treasury bills after years of negative IRRs. With an approximate IRR of 3.75% (before expenses) and a perception of relative security, Spanish families prefer this option for channeling their savings over others that, in theory, are more attractive. In the vast majority of cases, money market or short-term funds offer a higher IRR than treasury bills.
They also boast a better credit rating and greater diversification since they invest in a wide range of assets such as bonds, bills, promissory notes, or deposits. Moreover, as the different assets in the portfolio mature every day, they benefit from reinvestment if interest rates are higher, so they are a natural hedge against rising interest rates. When it comes to investing in treasury bills, diversification is limited, and we also face risk of reinvestment if, upon maturity, interest rates are lower than the rates prevailing at the time of purchase. Simplicity in evaluating an investment represents one of the key factors we need to consider before engaging.
This might be one of the reasons why treasury bills have experienced significant success in 2023, as many investors view them as akin to investing in “forgotten” deposits. However, the fixed income landscape has changed a lot in the last two years, and now opportunities abound. Do not settle for simple: study and compare the three theoretical variables mentioned at the beginning of the article, and if you are still unsure, seek professional advice. After all, they are the experts.