By Sterling Xie. Edited by Swastik Patel
We’re often told to “diversify our portfolio” to balance our investment risk, but we’re never told what that truly means. It could mean investing in a variety of different sectors and risk levels of stocks, but it could also mean investing in a variety of different asset types, one of the most important and stable of which is bonds.
What is a bond?
Bonds are like loans to corporations or governments (like the U.S.). They can be seen as an I.O.U. from a certain entity to the investor. There is a decided rate at which the borrower pays a certain percent interest. Bonds generate income through coupon payments, which are typically paid quarterly, bi-annually, or annually. Coupon payments are the sum of money an investor is paid in interest from the borrower. What is both critical and unique is that the full principal amount of the bond is returned to the investor at maturity, the date at which the bond expires.
Bonds can also be sold before their maturity on secondary markets. Investors can take advantage of rising bond prices and offer their bonds for sale at higher prices. This investment strategy is known as investing for total return.
Performance of Bonds
Bond values are affected by a variety of factors. One of the most important factors is the inflation rate. While investors that wait until full maturity do not need to worry about this since they will be paid in full, the value of bonds is important to those that want to sell on secondary markets. When the rate of inflation is higher than the coupon rate of the bond, the value of the bond drops. Conversely, when the inflation rate is lower than the coupon rate of the bond, the value of the bond increases. Bonds are also affected by market conditions (such as the state of the stock market), credit ratings that agencies give bonds, and the time until maturity of the bond.
Investors generally include bonds in their portfolio in the defensive asset class. Bonds are considered defensive because they are generally less volatile than other asset classes like stocks. This diversification helps lower the portfolio’s overall risk and volatility. That being said though, lower risk is also associated with lower return. According to PIMCO, while the average return from 1991-2017 of equities was around 30-40%, the average return of bonds was only around 20%.
Bond investors do particularly well during economic slowdowns. Slower growth generally means lower inflation, which makes the bonds more valuable. Additionally, because of the stability of the bond, while company stock prices are going down as profits are affected by economic slowdown, bonds still remain resilient. As such, they become very attractive to investors, increasing their value.
Bonds are an appealing class of asset that certainly belong in a portfolio. While investment strategy is certainly different for every person, bonds definitely need to be considered as a possible outlet for both capital gain and capital preservation.