The Role Of Bonds In An Investment Portfolio

Posted by John Adam on June 11
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I will, and I’m sure you’ll be grateful, resist the shameful urge to make a ‘Dad-joke’ 007 pun in this intro to the role of bonds in an investment portfolio. So, moving swiftly on…

The classic online investment portfolio will have allocations to equities (company stocks), bonds and some cash. There are other kinds of investments out there which can also have merit when diversifying an investment portfolio. But equities, bonds and cash are the nuts and bolts of a low-maintenance, online-only approach.

It is probably fair to say that bonds get less coverage than equities. As a result, their important role can sometimes be overlooked. That is probably because the kinds of bonds that form part of a classic investment portfolio are not hugely exciting. But it’s exactly in that lack of excitement that the value of bonds lies.

Equities are expected to provide the growth that will help increase the value of an investment portfolio over the years. Bonds are the quiet stabilisers that help smooth out the sometimes uneven path that stock markets can be.

It’s important to note that even if bonds theoretically represent ‘fixed income’, there is still a level of risk for investors. The risk is that the issuer doesn’t pay the agreed coupon over the lifetime of the bond or is able to redeem the initial value at the agreed upon maturity date.

Some bond issuers are considered to represent a higher risk than others and as a result have to offer a higher coupon to convince investors. But the kind of bonds expected to be found in a classic investment portfolio are usually those issued by politically and financially secure governments that have never not paid their issued debt, like the UK or USA. Or big, financially stable companies. Because these bonds are considered about as safe as a risk-based investment can be, they tend to offer only modest coupons.

The Value of Bonds Is In Their Low ‘Correlation’ To Equities

Low risk bond coupons have historically, over the long term, delivered lower returns than equities. But their role in a portfolio is not to try to match or outperform equity returns. It’s to smooth out the volatility of the ups and downs of stock markets.

When stock markets are going down, investors tend to invest more in bonds for safety. And because bonds like UK government gilts are still traded, this normally pushes their value up. So when stock markets are going through a rough spell, bonds typically move in the opposite direction to equities - their value increases. So bonds’ ‘correlation’ to stocks - how similar their price movements are on average - is low.

Research published by investment bank JPMorgan Chase puts the 10-year correlation between the FTSE 100 and UK gilts at -0.3, which is low.

Lower Volatility Can Improve Investment Returns

As a result, investment portfolios that have part of their value invested in bonds wouldn’t generally be expected to suffer the same losses as those invested only in stocks during a stock-market downturn. They also don’t usually have quite as strong gains during the good times. In other words, they are less volatile.

A recent post in Forbes magazine, written Benjamin Halliburton of Tradition Capital Management, reconfirms many independent studies over the years that have shown how, when all else is equal, portfolios with lower volatility deliver better long-term returns that those with higher volatility.

Bonds Can Help Boost A Portfolio’s Capital Preservation Qualities

The importance of the role of bonds, and how much of the total capital in a portfolio is invested in them, usually increases as the investor gets closer to retirement or cashing in assets. At that point the investor may not have the time to wait for stock markets to recover if they enter a downturn. Capital preservation, limiting losses as much as possible, becomes a higher priority than growth.

So even if low risk bonds like UK government gilts are less ‘exciting’ than stocks and shares and less is written about them, it’s important that investors don’t forget their value to the long term health of an investment portfolio.

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Written by John Adam

John has almost 10 years of experience as a writer and editor on consumer finance and investment topics. An entrepreneur, he has one successful exit behind him and currently writes and consults freelance while enthusiastically pursuing hobbies he's not very good at such as football, squash and raising a small child.

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