Why Bonds Matter… And How They Can Help You
Director, Portfolio Specialist
- Bond markets are dominating headlines, which is a rare occurance.
- While a relatively unexciting asset class, bonds can offer a solid source of income.
- Some bonds also offer diversification benefits. Specifically, government bonds can play a positive role.
- Bond yields can hint at recessionary risks, although context and valuations must be considered.
- To be effective, we must consider bonds holistically, always thinking about reward for risk.
You might be wondering what all the fuss is about bonds at the moment… Let’s face it, bonds rarely dominate the headlines. Yet, with recession risks rising, many are looking to the bond markets for clues and protection.
In this sense, we should first offer perspective. Fixed-income markets have enjoyed one of the greatest 30- to 40-year bull markets in history. With bond yields falling from highs of over 15% in the early 1980s to lows of around 1% today, the asset class has delivered unprecedented outcomes for cautiously-minded investors on a risk-adjusted basis. In many ways, fixed income has been akin to the world’s greatest defence, with an ability to score goals (deliver returns) and never concede (rarely suffering downside risk).
The challenge is that the next 5, 10 or 30-40 years may not be the same. So, given this dynamic, why do bonds matter and how can they help you? We instil three key pillars of thought below, hopefully highlighting the compelling story of opportunity and risk management.
How Bonds Can Help 1: As a Source of Income
Bond investing is conceptually quite simple. A government or company needs to raise capital, so will issue bonds at a fixed rate of interest. This rate depends on the quality of the company (a higher risk corporate will need to pay higher rates to compensate for risk) and the time horizon they want the money for.
So, as an investor, you can lock in the current rate and—assuming you are willing to hold for the full maturity—will get your money back along with the income along the way.
How Bonds Can Help 2: As a Diversifier
One of the great features of holding bonds is that they bring something different to the table, specifically by diversifying equity risk. During episodes of sharemarket panic, bonds tend to be more resilient, offering some offset to equity losses.
To be effective though, it is important to differentiate between government bonds and corporate bonds. Corporate bond returns can be correlated with equities, as they tend to share the same underlying cashflow risks, for instance, if a company goes bust, both the stocks and the bonds of that company will fall. On the other hand, government bonds tend to be more protective during periods of market panic for three key reasons: 1) they are considered to have little to no default risk and offer a lot of liquidity, therefore benefitting from a ‘flight to safety’, 2) the rates on offer tend to be tightly linked to the health in the economy, benefiting if interest rates get cut, and 3) they often involve longer holding periods, which increases the sensitivity to changes in interest rates.
It is important to note that many government bond markets are currently offering low yields, which has reduced their ability to provide diversification in the event of equity market weakness. For instance, U.K. government bonds will now give you less than 1.0% over a 10-year period, despite the political turmoil amid Brexit. In this environment, it is important to be selective, and as such, we favour shorter-dated bonds, especially in the U.S, which offer greater value than longer-dated bonds.
How Bonds Can Help 3: As a Recession Signal
Headlines throughout 2019 have been dominated by the concept of “yield curve inversion” (where bonds with a longer time to maturity yield less than those with a shorter date) and recession risk. Historically, bond markets have offered a useful signal of recession risk during rare but specific periods. We are now in the midst of one of these periods—at least in the U.S. market—raising concerns about everything from jobs to stock markets.
The real question here is whether bond investors have predictive abilities over the economy or markets. When it comes to managing a portfolio, we only really care about the markets, where the relationship is tenuous at best.
Picking the Right Bonds to Support a Portfolio
At this juncture, it is healthy to remind ourselves of the two key roles lower-risk bonds play in a portfolio: 1) as a source of return, and 2) to diversify equity risk. Like any asset, the risk and reward for bonds evolves over time, subject to changes in levers such as rates, quality, the time to maturity and liquidity; to name a few. It is therefore important to keep monitoring these levers. At present, we find a troubling mix of lower yields with higher risk.
If we use a soccer analogy, we know that a well-constructed team requires a mix of strikers, midfielders, and defenders. For government bonds, they may not offer much by way of attack (poor long-term return prospects due to the low rates on offer) but have had an ability to hold up defensively when called upon (especially if stocks sell off). The key is to consider the opportunity set holistically and not rely on any one player.
Balancing this, we tend to find our portfolios have a greater weight towards those assets we believe can best withstand the headwinds. These includes shorter dated bonds; bonds with higher rates or yields (greater income); and higher credit quality (downside protection). Otherwise, we prefer to hold healthy levels of cash, offering ammunition should conditions worsen. As ever, risk and return must always be weighed in unison.
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