Why we hold bonds

Why we hold bonds

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Of all the questions we are asked about the portfolios which we create and manage for our clients, some are more common than others.  You might expect that people would be most interested in the assets which make up the growth component, particularly as this is where we expect most of the long term returns to be generated.  Growth assets such as equities are also the ones which journalists, commentators and even the bloke at the golf club are most likely to discuss as they tend to be the area where it is possible to make the most spectacular gains.

However, certainly in recent years, the question which crops up most frequently concerns bonds, particularly government bonds.  Bonds are issued by governments, companies and other bodies as a way of raising finance at a fixed rate of return.  Compared to the glamour of equities, investors tend not to make huge profits (or indeed huge losses) investing in the bond market unless they are making heavily geared large bets.  Such practices are normally the preserve of hedge funds and so the everyday investor only hears about them when something goes horribly wrong.

It is certainly possible to use bonds from riskier issuers (of whatever type) as a means of hopefully generating long-term returns.  However, even if things go entirely to plan and every payment is made on time, the maximum return that an investor who purchased at issue will receive is the specified interest payments and 100% of their capital back at the end of the specified term.  This contrasts with an equity investor, who has an effectively unlimited upside as their return reflects entirely what another investor is willing to pay them for their holding.  The danger with bonds from such issuers is that one or more of the payments is not met in full.  Potentially this could include some or all of the final repayment of capital.  While for an investor, missing out on a single interest payment is unlikely to be catastrophic, the same may not be true of the final capital repayment.  Since risk and return are related, those bonds which the market sees as being lower risk have lower returns; unsurprisingly, the opposite also holds true.

However, assuming that you limit yourself to investing in bonds issued by institutions with a low likelihood of defaulting on either interest or capital payments, their role in a portfolio is usually to limit the extent to which fluctuations in the value of the growth element impacts on the total.  As those who held a diversified portfolio during the market falls of March 2020 will have noticed, as well as being less volatile than equities, bonds also tend to move in the opposite direction to them, particularly when markets are stressed.  Being able to limit the magnitude of fluctuations in your portfolio’s value is important, particularly if you are drawing on it to meet your lifestyle costs.

It is unlikely to have escaped the attention of many that in the last few years, the interest rates available on cash accounts have continued to fall, a trend which has been underway for considerably longer.  Although not directly linked to cash returns, the yields from bonds have also fallen as bond prices have risen in recent years.

Like much in the field of economics, the relationships which govern investors’ expectations for bond (and equity) returns, between economic growth, inflation, interest rates and corporate profits are complex.  While bond and share prices usually move in opposition, this is not always the case and investors should not expect that the future will be different.  Furthermore, not all bonds behave the same way in the same economic conditions.  Lower quality corporate bonds, for example, are commonly affected by the same factors which drive equity returns.  Long-dated (maturing in more than 15 years) bonds are particularly affected by long-term expectations for inflation.  Short-dated (maturing in under five years) bonds are affected much less by this and since the portfolio is renewed more frequently as issues mature, generally exhibit more stable returns and act as a better inflation hedge.

Nevertheless, even though bonds do sometimes move in the same direction as equities, most of the time they do not.  This provides an important benefit in a diversified portfolio as even if they do fall when equity prices drop, they tend to fall less and for a relatively short period of time.  This helps to preserve the value of the portfolio compared to being invested entirely in equities.  Furthermore, once governments and central banks have acted, the typical inverse relationship between bond and equity prices is restored.

As long as it is derived from a financial plan, the purpose of investing is to achieve your particular goals over your particular timeframe.   It should enable you to do so with a degree of risk with which you are sufficiently comfortable that you can afford to stick with your strategy regardless of the market is doing.  As long as your portfolio is able to achieve this, worrying about the extent to which it is beating some national benchmark which another investor may be using is an unproductive activity.  While there is always someone who is keen to promote something different, whether it be property, gold, hedge funds or Hungarian forestry, none is necessarily as ideal as it may first appear.  There is no perfect investment with low risk and high returns and even those which may appear to offer both often have problems with liquidity.  These may only become apparent when it is too late.

Investing in bonds may be boring but for us that’s really the point of holding them – if the bonds in our clients’ portfolios were exciting, then we’d be looking at replacing them with something more likely to achieve the same goal.  Chances are, that would still be bonds.