Markets have been volatile this year and bonds can be a great way for investors to diversify their portfolios, as they have different characteristics to shares and property.
Bonds sit within the defensive part of an overall balanced investment portfolio and can help reduce volatility and preserve capital, especially for investors with exposure to shares.
Some people feel anxious when it comes to understanding bonds, so here are five key facts to help you better understand this asset class.
1. Why hold bonds?
A well-diversified, actively managed fixed income fund should play an important role in an overall investment strategy regardless of the market environment. Here’s why:
Fixed income investments can be appealing to risk-averse investors such as those nearing or in retirement. A diversified portfolio of fixed income securities tends to be much less volatile than an equity portfolio, which means it is less likely to incur large losses in a short period of time. The basic principle of fixed income securities is the repayment of principal at maturity. Investors are repaid the money they originally invested at the end of the agreed period.
While many investments provide some form of income, fixed income investments tend to offer attractive and reliable income streams. A diversified fixed income portfolio should provide income with a lower level of risk than equities, and may offer higher income than money market funds or term deposits.
As fixed income assets often perform well at different times to equities, they can help to provide portfolio diversification, which over the long-term can provide investors with better risk-adjusted returns.
2. Types of fixed income
Fixed income is a broad asset class. The most common are commonwealth government, state government, corporate bonds, and asset-backed securities such as mortgage-backed bonds.
The yield is generally higher for corporate bonds compared to that of government bonds. This is because the perceived risk for investing in corporate bonds is higher. Mortgage-backed bonds have a yield that typically exceeds high-grade corporate bonds with comparable maturity and differing levels of credit risk.
|Government||Government bonds are issued by the Commonwealth and by the states.
Governments issue bonds to pay for government activities and pay off their debt
|Corporate||Corporate bonds are also referred to as credit. Corporations issue bonds
to expand, modernise, cover expenses, and finance other activities.
|Asset-backed||Banks and other lending institutions pool assets, such as mortgages, and
offer them as security to investors. This raises money so the institutions can
offer more mortgages.
Within corporate bonds, there are a number of classes of debt, ranging from senior bonds to preferred securities. Senior bonds have greater seniority in the issuer’s capital structure than subordinated debt and preferred securities. This means that in the event the issuer goes bankrupt, senior debt must be repaid before other creditors receive any payment. Senior debt is often secured by collateral on which the lender has put in place a ‘first lien’ or legal right to secure the payment of debt. Equity holders in this situation would usually receive nothing.
3. The relationship between price and yield
If an investor purchases a new bond with the view of keeping it to maturity, then any change in the price of the bond, interest rates or yields would not be relevant. However, if an investor buys or sells an existing bond, the price that the market is willing to pay for the bond may fluctuate. As a result, the bond’s yield (i.e. the expected return on the bond) may also change.
The first, and most important, concept to understand when discussing bond yields is that bond prices and yields have an inverse relationship. That is, when bond prices go up, bond yields go down and vice versa. To understand why this is, it helps to see bond yields as a measure of the profit from a bond investment. The less investors pay for the bond, the greater their profit is likely to be and the higher their yield. Conversely, the more investors pay for a bond, the smaller their likely profit and the lower their yield.
4. The main drivers of bond prices
There are three main drivers of bond prices: inflation, interest rates and the financial health of the issuer.
When the inflation rate rises, the price of a bond tends to drop. This is because the bond may not be paying enough interest to stay ahead of inflation (a bond’s coupon rate is generally fixed and unchanged for the life of the bond). The longer a bond’s maturity, the more chance inflation will rise rapidly and lower the bond’s price.
This is one reason bonds with a long maturity offer somewhat higher interest rates to attract buyers who would otherwise fear a rising inflation rate.
When interest rates rise, newly issued bonds typically offer higher yields. When this happens, existing bonds with lower coupon rates become less competitive. This is because investors are unlikely to buy an existing bond which offers a lower coupon rate unless they can get it at a lower price. So, higher interest rates generally mean lower prices for existing bonds. Conversely, when interest rates fall, an existing bond’s coupon rate will usually become more appealing to investors, driving the price up.
Financial health of the issuer
The financial health of the company or government entity issuing a bond affects the price investors are willing to pay for the bond, as it impacts on the company’s ability to repay its debts. Usually, the financial strength of the issuer is rated by credit rating agencies.
5. The importance of managing risk
By investing in an actively managed, diversified bond fund, investors can spread portfolio risk. When investors have exposure to only a small number of securities this exposes them to a concentrated risk in issuers, industries or geographies, and a systemic event can impact a large part of the portfolio. Active bond managers will commonly adjust a bond portfolio’s duration to protect the capital value of the fund.
For example, a bond manager expecting interest rates to fall would normally ‘lengthen’ the portfolio’s duration by buying longer-term bonds and selling shorter-term bonds. This is because, in this circumstance, the price of a longer duration portfolio should rise more than that of a shorter duration portfolio. Bond prices can sometimes increase significantly more than ‘par’, and in the extreme case of a company defaulting, prices can fall to zero. That is why, unlike equities where one poor performing stock can be compensated with a strong performing stock, bond risk needs to be spread widely. This can be a critical way of riding through volatile markets.
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