Let’s talk about Bonds

The two major asset classes we use when building portfolios are ‘bonds’, also known as ‘fixed interest’ and ‘equities’, also known as ‘shares’. While equities are important in driving the growth of a portfolio, they are very volatile and carry considerable risk. On the other hand, bonds are seen as defensive assets that are essential in dampening portfolio volatility caused by the wild swings of the stock market. In the bad times bonds normally hold up and give us somewhere safe we can draw from if needed.

Bonds are viewed as being far less exciting than their close financial brethren: shares. The financial press typically dedicates its column inches and airtime to how the stock market has performed that day even though the bond market is larger by market capitalisation than the equity market. It is rare to hear an update on the bond market.

The main reason is obviously the volatility of the stock market makes for dramatic headlines, but at its essence the return profile of each asset class is very different. As bonds are debt instruments, they offer a predictable ‘fixed’ known return, whereas in contrast holding equity securities entails owning a stake in a company, and as such you participate in the performance of the company. The returns in theory have no limit. For example, since its IPO in 1997 Amazon’s share price has grown by almost 100,000%! Much like playing the lottery or gambling on the horses, we know the odds are stacked against us, but we are still excited by the idea of getting lucky and picking a winner.

After years in the shadow of equities, bonds are now in the news for all the wrong reasons (if you are unsure of what bonds are please see the explainer at the bottom of the note). The sustained global rise in inflation has seen bond prices fall across the world. There are two reasons why Inflation is terrible for bond investors. First, inflation erodes the real value of the bond’s interest and principal payments. Secondly, in response to persistent inflation central banks typically increase interest rates to cool inflation, this causes bond prices to fall further as yields adjust to the new rate. This begs the question should investors own bonds in a rising rate environment? While the outlook is bleak, on balance bonds still play a vital role in diversifying investment strategies.

Short term performance of any asset class is unpredictable, and as investors we can’t help but become fixated on the recent past, if we are not careful it can easily cloud our judgement and cause us to make knee jerk decisions that have negative consequences for the long-term health of our portfolios.

Whenever an asset class, geographical region or risk factor is underperforming it is never good to panic and sell. Instead, it is worth revisiting the rationale for having the holding. In the case of bonds now is a good time to review the fundamental features of investing in bonds.

There may be an understandable urge to sell bonds after the recent increase in rates which has driven down prices, but this would be simply chasing past performance. If instead we look forward, rising yields should mean higher future returns, as such the outlook for bonds is actually better now than before yields went up and the risk of capital loss has also fallen. The upside of higher interest rates equals higher yields, too often investors focus on the short-term negative sentiment around an asset and fail to see the longer-term implications.

The fall in bonds and the considerable increase in yields mean that the chances of losing money in bonds in any given year have reduced. Moreover, higher yields give portfolio more protection from the threat of rising interest rates.

Long term strategic allocation to bonds indicate that now is a good time to rebalance portfolios into bonds as their prices have moved significantly, unlike market timing portfolio rebalancing is a disciplined approach to portfolio maintenance that ensures investor emotion does not drive decision making. Moreover, at fund level the collective bond funds you invest in hold multiple bonds with differing maturities and yields, the funds reinvest these coupon and principal payments back into bonds at higher yields, enhancing long term returns.

As markets are forward looking the consensus already suggests that rates will rise further therefore the prices of bonds already reflects this information so selling now is too late. There is no advantage to be had to dispose of bonds at this time.

High quality bonds are excellent portfolio diversifiers. Despite recent returns they do offer a promised return if they pay off and will earn interest along the way. The very nature of holding a diversified balanced portfolio means that at any one time there will be some asset classes performing well and other that are not. Assets that provide uncorrelated returns demonstrate the diversification benefits that a balanced portfolio of stocks and bonds offer. The result is that investors benefit from a better risk-return profile than a portfolio invested 100% in one asset class.

Bonds still perform several important functions in a portfolio, essentially helping us control the level of risk. As mentioned earlier they give a portfolio some ballast against volatility, they provide liquidity in times of stress, and they protect capital. Over the long-term equities are the key to building wealth, for the best results they need time to generate compound returns. When there is havoc in stock markets, bonds enable investors to maintain discipline, keep emotions under control and ensure that equities can have time to recover.

Often the best course of action is to do nothing, we should not forget that bonds have had a great run over the last few decades and may continue to do so. Now that rates have begun rising further it is not really news anymore. The future is unpredictable, and no one knows the future direction the economy or interest rates will take. There are a range of possible future outcomes, so we should not make investment decisions based on what we do not know.

James Bacon BSc (Hons), MSc, Chartered MCSI, APFS

Chartered Financial Planner, Wealth Manager

June 2022

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