The enduring relevance of bonds: Why they still matter in a diversified portoflio.
Written and accurate as at: Oct 11, 2023 Current Stats & Facts
Investing isn't a one-size-fits-all approach; it's more like a tailor-made suit carefully stitched to fit an individual's needs and objectives. In Australia, there's a rising interest in equities and property, often seen as attractive options for high returns. However, bonds, a less glamorous but equally important asset class, should be noticed. While some may consider bonds as the financial equivalent of watching paint dry, there are compelling reasons for Australians to include them in a diversified portfolio.
A Primer on Bonds
Bonds are IOUs issued by governments or corporations, promising to pay the holder a set interest rate over a specified period. At the end of this period, known as the 'maturity date', the bondholder receives the initial sum invested, called the 'face value'. In Australia, popular bonds include government, corporate, and even 'kangaroo bonds' issued by foreign entities in Australian dollars.
Stability Amid Volatility
When economic uncertainty looms, bonds are like the sturdy anchors of the investment world. They provide a fixed income, shielding investors from the wild fluctuations often experienced in equity markets. As Australia navigates challenging global economic conditions, including ongoing trade tensions and the aftermath of natural disasters, the stability offered by bonds becomes even more attractive.
Regular Income Stream
Bonds are not merely placeholders for your money; they work for you, generating a consistent income stream. This regular and reliable income is particularly beneficial for those who require a stable income, such as retirees. Unlike dividends, the interest from bonds is a more reliable source of revenue.
Diversification
It's the golden rule of investing: don't put all your eggs in one basket. A well-diversified portfolio mixes asset classes, including equities, real estate, commodities, and bonds. Historically, bonds have performed inversely to equities, counterbalancing and reducing overall portfolio risk. During the 2008 Global Financial Crisis, bonds were among the few assets that generated positive returns due to the rush to safety, helping cushion the blow for investors. It is common for large bond funds to hold hundreds or even thousands of individual bonds.
Low Default Risk
Especially for those considering government bonds, the risk of default has historically been relatively low. In Australia, government bonds come with a sovereign guarantee, meaning the chances of not getting your money back are exceedingly slim. While corporate bonds may offer higher yields, they come with higher risks, but this can be mitigated by focusing on bonds with high credit ratings. However, suffering a default event is not impossible. Take, for instance, a second Chinese property developer, Country Garden, who is warning of a possible default in the coming days. Remphasising the need to diversify.
Liquidity
Lastly, bonds are relatively liquid and can quickly convert to cash when required. The ability to sell is critical if an unexpected need for funds arises or if you identify another investment opportunity and wish to make a quick move.
In an environment where interest rates have hovered near zero, the yields on bonds have been understandably lacklustre. Recently, as interest rates have increased, bond prices have taken a hit, raising questions about their relevance in a portfolio.
However, it's essential to remember that investing is not about what has just happened but what will happen next. While the past five years have been challenging for bonds, the following five could tell a different story. Economic conditions, inflation rates, and monetary policy are ever-changing variables that can impact bonds differently over time. Just because bonds have been underwhelming performers recently doesn't mean they will continue to be so.
As part of a well-balanced portfolio, bonds offer more than just returns; they offer a degree of security that's hard to find elsewhere. While they may not provide the glamour of equities or property tangibility, bonds remain strategically important.
In summary, even if bonds have been comparatively lacklustre in recent years, it's unwise to write them off entirely. The case for including bonds in your investment strategy remains compelling. They offer a combination of stability, income, diversification, low default risk, and liquidity that's difficult to ignore. As we look ahead, consider bonds not for what they have been but for what they could be: a valuable component in safeguarding and growing your wealth.