Saxo CEO Adam Smith talks us through the role of bonds in your investment portfolio, as well as some of the risks and benefits.
As global share markets remain hostage to inflation, increasing interest rates and other economic data, it could be time to look further afield for other investment opportunities that may generate returns. One asset class that is very popular overseas and is starting to gain traction here in Australia is fixed income. Bonds are the most common form of fixed-income securities.
A bond is a so-called debt instrument that pays a fixed amount of interest, usually at regular intervals typically distributed annually or semi-annually. The initial investment amount (also known as the principal) is paid back to the investor when the bond expires (known as maturity).
So, a bond is actually a loan that the bond purchaser, or bondholder, makes to the bond issuer. Governments and corporations (including banks or companies like Apple and Microsoft) will issue bonds when they want to raise capital for a variety of reasons. An investor who buys a government bond is basically lending the government money. If an investor buys a corporate bond, the investor is lending the corporation money. So, if you buy a bond from a bank you are actually lending to them – not the other way around for once!
Like any investment, investing in bonds is not without risk. Every bond carries some risk that the issuer will “default,” or fail to fully repay the loan (or principal). It is the job of independent credit rating services (Moody’s, S&P etc.) to assess the default risk, or credit risk, of bond issuers and publish credit ratings that not only help investors evaluate risk, but also help determine the interest rates on individual bonds.
Generally, investors should be paid more in interest if they take a greater risk of not getting their initial investment back and vice versa. An issuer with a high credit rating will pay a lower interest rate (as its cashflows have a higher certainty of being paid, so it is a relatively less risky investment) than one with a low credit rating. Again, investors who purchase bonds with low credit ratings can potentially earn higher returns, but they must bear the additional risk of default by the bond issuer.
The role of bonds in a portfolio
Experienced investors appreciate the need for diversification in their investment portfolios. An allocation of some part of your portfolio into bonds can help you achieve this. Investors purchase bonds for a number of reasons: capital preservation, income, diversification and as a potential hedge against economic weakness or deflation.
Capital preservation: Unlike equities, bonds should repay principal at a specified date, or maturity. This makes bonds appealing to investors who want a small risk of losing capital. Bonds have the added benefit of offering interest at a set rate that is often higher than short-term savings rates.
Income: Most bonds provide the investor with “fixed” income. On a set schedule, whether quarterly, semi-annually or annually, the bond issuer sends the bondholder an interest payment, which can be spent or reinvested in other bonds. Stocks can also provide income through dividend payments, but dividends tend to be smaller than bond coupon payments, and companies make dividend payments at their discretion, while bond issuers are obligated to make coupon payments.
Capital appreciation: Bond prices can rise for several reasons, including a drop in interest rates and an improvement in the credit standing of the issuer.
Diversification: Including bonds in an investment portfolio can help diversify the portfolio. Many investors diversify among a wide variety of assets, from equities and bonds to commodities and alternative investments, in an effort to reduce the risk of low, or even negative, returns on their portfolios.
Potential hedge against an economic slowdown or deflation: Bonds can help protect investors against an economic slowdown for several reasons. The price of a bond depends on how much investors value the income the bond provides. Most bonds pay a fixed income that doesn’t change i.e. an investment in a bond provides an element of cashflow certainty for an investor.
How much of my portfolio should I allocate to bonds?
The honest answer is there is no one-size-fits-all answer to the question of how much of a portfolio investors should allocate to bonds, as the appropriate allocation will depend on a number of factors, including the investor’s goals, risk tolerance, time horizon and current market conditions.
That said, a widely circulated rule of thumb among financial advisors for determining an appropriate allocation to bonds is based on the investor’s age. With the assumption that bonds offer lower, but less volatile returns than stocks over time, the rule of thumb suggests that investors should subtract their age from 100, and allocate that percentage of their portfolio to stocks, with the remainder allocated to bonds.
For example, a 30-year-old investor would allocate approximately 70 per cent of their portfolio to stocks (100 minus 30), and 30 per cent to bonds. As the investor gets older and approaches retirement, the allocation to bonds would gradually increase, as a way to reduce overall portfolio risk and volatility.
It’s important to note that this rule of thumb is just one approach to determining an appropriate allocation to bonds and may not be suitable for all investors.
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