The case for bonds: The water for our whisky
Bonds tend to get a bad press.
Equities or stocks and shares get all the love and attention because they are more exciting and have attractive growth stories. Bonds are viewed as boring, low risk low return investments that are good for “widows and orphans”.
Recently bonds too have suffered as central banks round the world increase interest rates to combat inflation.
An important aside and a quick definition. Bonds are effectively IOUs or loans to governments for specific maturities which are tradeable. And here we are talking specifically about bonds issued by governments like the US, UK, Germany, France, Japan etc. For all intents and purposes there is no risk of default- it’s the risk-free rate.
Corporates, high yield and emerging market bonds introduce lots of elements of risk with which we are not comfortable, primarily the risk that they will go bust and not repay the capital. We tend to steer clear of these. If we want to try and achieve long term inflation busting returns, we buy equities.
So if bonds are boring and make little money, why do we include them at all in portfolios? Well for a number of reasons actually.
Bonds tend to hedge stock market volatility
This mantra has been put to the test this year as the stock market’s orderly decline has come hand in hand with rising rates and pressure on bond prices.
However going back to periods of intense market stress , such as in March 2020 or in the Great financial Crisis of 2008 and the big tech sell of in 2000-2002 bonds do their job as the anchor in a portfolio. Not only do they hedge against stock market downturns but they provide an emotional hedge.
They are the “sleep at night” bit of the portfolio.
Bonds can be used to rebalance
When the stock market sells off, if you are accumulating wealth that’s the time you want to dive in and buy with both hands for the long term. The only problem is you need capital to buy. You can use the money you have invested in bonds to buy more equities and bring back your asset allocation back to where it should be.
And you don’t need to dip into your current account to do so. Rebalancing is a systematic way to buy low and sell high, so when there is blood on the streets you sell some bonds and buy stocks when the market falls.
Bonds can be used for spending purposes
If for some reason you need to tap your portfolio to spend, or if you are in retirement and take cash out regularly, bonds are a lifeline. It’s difficult emotionally to sell shares if they are down 30%. Bonds provide stability for those who need to use their portfolios for living expenses or large purchases.
It’s best of course to use cash in these circumstances – as you set aside emergency money or reserve money for big, short term capital spending. However, it’s good to know that there is a relatively stable source of funds there if you need it.
Bonds protect against deflation
Clearly as we have seen this year, inflation hurts bond prices as interest rates and yields go up and the prices go down.
Many economists though take the view that this current post pandemic war inflation is transitory and will eventually come down (how long this transition lasts is another question of course). Central bank policy is that interest rate increases will engineer a recession, dampen demand and bring down prices.
The Bank of England expects inflation to come down to 2% in two years. In a disinflationary or deflationary environment, bonds are actually worth more not less over time. And as interest rates come down again, bond prices go up.
Sometimes, bond yields can even be negative as we have seen recently in Europe and Japan.
Bond funds reinvest income at higher rates
The advantage of bond funds (which our portfolios prefer) rather than single bonds, is that over time, in a rising interest rate environment, as income from the bonds is paid out within the fund and as individual bonds mature, this money is recycled into bonds with higher yields.
Over a period of time therefore, the funds automatically replace lower yielding bonds with higher ones increasing returns. Doing this on your own would be a real hassle.
The truth is – there are no easy answers in the current low-rate world we live in. You can either earn less income to better protect your capital or more return to accept more risk.
If you are not sure, it may be best to include a bit of both – add some water to your whisky.
It may just save you from a nasty hangover.
For a discussion about your situation and what this might mean for you and your investments please get in touch!
Please note
This guide is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.
The value of investments may go down as well as up and you may get back less than you invest.
Past performance is not a reliable indicator of future performance.
