Bonds are often the black sheep amongst the asset class due to their low returns and lack of hedging power against inflation. With that being said, there are some positive attributes to bonds that secure your overall investments. Hence, the question is, should it be discarded entirely from an investment portfolio? Or should we tweak its allocation for better performance?
Here, we will look at the characteristics of bonds and studies to support why you should not totally ignore bonds from your portfolio:
Bonds are an investment instrument that allows people to lend money to the issuer in exchange for a fixed income. It is a way for the issuer to raise capital while the lender earns interest from it. It is a long-term debt to the issuer and is considered generally stable due to its lower risk. Bonds have their own variants in terms of their maturity and structure. Short-term bonds are usually around 5 years or less and usually, yield higher interest rates than long-term bonds. However, long-term bonds are more stable and carry less risk than short-term bonds. Bonds with a zero coupon structure do not pay interest. Rather they are issued at a discount. Bonds with fixed coupon rates pay interest on a fixed-term basis until the end of maturity.
There are two types of bonds available for you to invest in:
Government bonds are considered the safest investment since their issuer is the state itself. The value of a government bond is maintained by national support, and its stability relies on the nation’s economic circumstances. Local municipalities within a state can also issue their versions of government bonds, called municipal bonds.
You can enjoy a number of benefits from owning government bonds, such as its low risk of default since the government is backing it. Unless the whole country goes bust, which is a rare scenario, your investments in government bonds are not likely to suffer. If there is a credit risk for any economic reason, the state can increases taxes to make amends. You can also get tax breaks from owning government bonds. Depending on the issuer and the type of bond, the tax advantage can vary. Some bonds are exempt from local taxes if the municipal laws differ from state laws. Other bonds are exempt from taxes if they were issued to finance public projects, such as hospitals.
However, since default risks are low, the yield of government bonds is also low. They may also lose their value if the interest rates are above the principal value because their prices decrease when the market interest rates increase and vice versa. They are also not immune to inflation. Since inflation eats your purchasing power, your interests out of those bonds are now less valuable, hence making the bond less valuable.
Like government bonds, its issuers are corporations or companies that raise capital to fund their business operations. Corporate bonds are generally short-termed and are tied to the business’ success. Hence, they can offer higher yields than government bonds. They have lower volatility than company stocks and are more liquid and more diverse. You can also trade them in the secondary market after issuance to sell them if the price increases or buy them if the price decreases.
The cons of corporate bonds are usually related to the company’s profitability - if the company itself is in a riskier position with a lower investment grade, its issued bonds will also carry the risks. If the company goes out of business, you will lose out on your investments. Companies in riskier positions can issue bonds, and in those circumstances, the bonds will be called junk bonds or high yield bonds. These bonds carry higher risks of default and need a higher yield to offset the risks.
The strengths and weaknesses of bonds are not new to investors. What is important for you to understand is its purpose in an investment portfolio and its current power in the global market.
Unlike securities, the role of investment, bonds is not to bring high income. Its purpose is to provide safety to your portfolio. In good market times, both bonds and securities will provide you with a high yield, but bonds will cushion your portfolio in times of market crash so that you do not lose everything. Bonds are meant to diversify your portfolio between high returns and high risk. Combining securities and bonds is an optimal way to create a stable portfolio that will yield a generous return on interest on top of diluting your risks.
Bonds in Europe have been a success in the past as a method of raising capital for corporations due to their low interests. Around 30% of the global bond market belongs to Europe. For you, as an investor, it means that bonds can provide security due to their popularity amongst issuers.
Although bonds in Europe were facing inflation in the first 3 months of 2021, their yield increased significantly later. Data shows that junk bonds or High-yield bond have been doing particularly well in 2021 despite the pandemic and is forecasted to yield around 3 to 5% in 2021. This is due to several factors such as government and central bank stimulus boosting demand.
Although future markets forecast on bond yields are to be taken with a grain of salt, the research on it ought not to be ignored as bonds, as an asset class, still carry significant value in the global market. Understanding its purpose will clarify your financial goals in terms of desired returns against risk tolerance. It will encourage informed decision-making in incorporating bonds in your portfolio.
Last update: 05/08/2021