By Aidan Hackett. Edited by Arjun Chandrasekar.
What are Bonds?e
A bond is a unit of debt, usually issued by a government or company. They have regular payments called coupons (physical bond certificates used to have physical coupons attached to them) and are guaranteed to hold their value if you wait for their expiry (unless the business goes bankrupt, in which case your shares/any other investment would be worthless too). Because of these two reasons, bonds are viewed as a low-risk asset.
Bonds can be of different risk categories. Government bonds are generally considered the safest – when does a government default on paying loans? (and if the government did collapse and they were unable to pay out bond holders, you’d probably have bigger things to worry about). After the government are big, stable companies – think Microsoft, Berkshire Hathaway, Walmart, etc. You then have less stable companies, and then, passed a certain threshold, bonds are considered “junk” – They are not investment grade. Bonds can also cover things like mortgages, consumer debt, etc.
What is a portfolio?
The term portfolio comes from a time when people literally had folders and binders to hold all of their documents, but now it is used to describe the entirety of an investors assets, be it stocks, property, or indeed, bonds. The goal of a portfolio is simple – maximise returns for the amount of risk assumed by the investors.
Risk adjusted returns are important for looking at a portfolio’s returns, as it gives a bigger picture. Note, risk is measured by the magnitude of the returns standard deviation. To illustrate this, take two portfolios, A and B. Both of them have achieved an average return of 12% over the last three years. Portfolio A did this with a standard deviation of 2% (i.e., 95% of returns will be between 8% and 16%), while portfolio B did this by returning 20% (i.e., 95% of returns will be between -28% and 52%). Which portfolio would you prefer to own? Portfolio A would be the most responsible answer as you would be more likely to be profitable in any given year. Portfolio B is wild and all over the place, so the returns are poorer on a risk-adjusted basis, as on any given year you have a comparatively large chance of losing a lot of money.
Generally, investors try to minimise their risk, and that is where bonds come in.
Role of Bonds in a Portfolio
As has already been established, bonds are less risky due to them usually having fixed payments, and the fact they have a guaranteed value at a predetermined expiry date. Also, in the event of bankruptcy, bond holders (debt holders) get paid before shareholders (equity holders). This lower risk comes with a caveat, however. Average bond returns are almost always below the average stock market returns. For example, if you’d have bought $1000 of US 10-year treasuries (treasury=bond) in 2011, you would have $1313. A modest 31.3% return over 10 years. For comparison, the S&P 500 returned 247% over the same period.
So then, why do investors choose bonds? For security. It may be hard for us to understand as people who are constantly bombarded with stories hailing from the wallstreetbets subreddit of people pulling off 100%+ returns within a week, but some people’s only aim is to beat inflation by a few percentage points. That is where bonds come in. When you want to smooth out your returns, you buy bonds. When stocks go down, bonds generally go up. When stocks go up, bonds still go up, but less than they did before. The income generated provides a lot of stability in portfolios.
Bonds are not all buy and hold, however – they can be bought and sold, and with a little leverage, provide respectable returns, even by the standards of the share market. Before we explain this, a little bit of background. Bonds coupon rates are positively correlated with interest rates. So, if government A was offering a $1000 bond with 4% coupon rate, but suddenly interest rises and the going rate is $1000 for 6%, then naturally the 4% coupon bond will fall in price. So now consider how you could potentially trade bonds. While this does require macro-economic knowledge (which you can gain by clicking here), trading on interest rates can be profitable, and if leverage is used, these returns are nothing to turn your nose up at.
Conclusion
Bonds are investments with a lot of interesting characteristics and behaviours. They simultaneously provide one of the lowest risk and best income paying investments, while providing investors with an opportunity to play a game with interest rate predictions. While bonds are typically viewed as a tool for retirees to conserve wealth and get paid interest, they are a valuable part of any responsible investor’s portfolio.
