A layman’s guide to understanding bonds: Part III

A layman’s guide to understanding bonds: Part III

To help you get you head around bonds, Market Index recently launched a series of articles on bonds within an Australian context.

In part I we talked about making sense of bonds, shades of risk, how the bond rate is set, and how long you need to lend your money for.

In part two we looked at the three basic options for having your interest paid, and what happens if you decide to ask for your money back early (aka before maturity).

In part three we’re going to look at the role bonds can potentially play in your portfolio, and why you might buy a bond.

The role bonds can play and why you might buy them

Given that bonds are by nature defensive assets, their role within your portfolio is first and foremost about the diversification they bring to your overall asset mix.

Just like a fund manager will use hedges to minimise the downside for investors, you can deploy bonds to smooth out the volatility within a diverse asset mix, where each asset class is designed to perform a different role.

But remember, this strategy assumes you’re invested for a least three years, otherwise simply holding cash may be a preferred option.

Bonds can offer income and capital preservation

Put simply, bonds have a different return profile to shares, and as such offer greater stability of returns. While risk assets like shares are typically bought for growth, the role of bonds is to generate income and preserve capital.

By doing that they help to offset any losses from the non-performing assets within your portfolio.

To understand why bonds can play this role, it’s important to know that as an asset class they’re what are referred to as ‘uncorrelated’ with equities. In other words, when equities perform well, bonds typically don’t.

Hence, during a steep stock market decline, government bonds tend to appreciate, serving as a valuable offset for those losses.

It’s when large-blend stock funds are performing badly that government-bond funds are more likely to be in the money.

Corporate versus government bonds

But it’s important to distinguish between government bonds and corporate bonds when it comes to the diversification they can bring to a portfolio.

For example, government bonds tend to be the defensive of the two during market panic, due to having little to no default risk and being generally very actively traded.

As a result, prices can rise during market turmoil as investors seek safe havens.

Government bond yields also tend to be directly wired to the state of the economy, and prices benefit if interest rates are cut.

Given that government bonds tend to have longer holding periods, price and yield are more sensitive to changes in economic conditions.

Bonds can help you ride out the bumps

While an experienced long-term investor may choose to ride out the ups and downs in the market, a well-diversified portfolio can help even out bumps on the way to reaching a desired goal.

As a safe-haven asset class, bonds can also be relied upon as a hedge against economic slowdown.

While slower growth usually leads to lower inflation, this can make bond income appear more attractive.

The income from bonds comes in the form of income payments and are typically paid quarterly, twice yearly or annually. These payments can be used to help supplement living expenses or can be reinvested.

It’s true, shares also provide income in the form of dividends. However, dividend payments are less reliable than bond coupons, and since the pandemic many of those dividends have fallen away and are yet to return in full.

Bonds can offer capital growth upside

The other important role bonds can play is around the certainty they offer regarding the preservation and return of capital.

Interestingly, while bonds aren’t typically bought for capital appreciation, this also is possible by taking advantage of rising bond prices by selling prior to maturity on the secondary market.

It’s during periods of stock market declines that bonds are most likely to gain in price.

This strategy is often referred to as ‘investing for total return’ and is popular with more experienced bond investors.

In part IV we’ll look at the risks of owing different types of bonds.