Bonds: Why they should be in your portfolio

Bond markets have experienced a poor start to the year, with interest rates in many countries increasing and projected rate rises. It is a unique aspect of bond pricing that when interest rates rise, two things happen:

1. The prices of existing bonds go down (which happens immediately).
2. The expected future returns of those existing bonds go up (with these higher returns delivered over time).

In this regard, falling bond prices are felt immediately in portfolio valuations, while the higher expected future returns are only received in the following months. One small comfort from this is that with current bond yields now much higher than they have been for several years, the expected future returns from bonds are looking increasingly attractive.

Market expectations about interest rates have changed dramatically and are now focused on inflation. Supply shortages, logistics problems, workforce constraints, and international energy disruptions have pushed prices higher across many goods and services. Bond markets have absorbed this information, and investors are now seeking a higher return on bonds. In response, bond prices have decreased, and many investors have received negative returns.

It’s important to point out that the poor recent bond returns are not necessarily the result of fund management choices or the underlying bonds’ credit worthiness. Poor returns are mainly due to investors expecting inflation and requiring a higher yield.

While that explains what happened, the question remains; should you still own bonds in your portfolio?

The answer, in general, is yes, although we always need to consider individual circumstances. Here are five reasons why bonds should be included in a diversified investment portfolio:

1. Bonds are still a good diversifier

Historically, bonds have been an excellent diversifier to shares. Since 1993 (as far back as we have NZ data at our disposal), there has been only one other calendar year where bond and share prices were hostile; in 1994, we circled below. By contrast, we can look at 1998, 2000 and 2008 and see where bond prices went up while share prices went down – providing that diversification benefit investors are looking for.

2. Bonds help control volatility

Another illustration of the above chart is the narrower range of returns. While returns from shares can range from positive 50 percent to negative 40 percent, returns from bonds have never exceeded 20 percent in either direction. An appropriate allocation to bonds will reduce the volatility risk for your portfolio, which is especially important if you have a shorter investment time horizon.

3. Bonds are still creditworthy

The bond funds used in our portfolios are overwhelmingly comprised of bonds selected from investment grade-rated borrowers (BBB, A, AA, and AAA). Those borrowers, including the New Zealand Government, will likely pay back the bonds. If investors hold on for the long run, they will likely receive a positive return from those borrowers making their scheduled payments.

4. Increasing rates are priced in

But what if interest rates go up more from here? Won’t that lead to lower bond returns? Not necessarily. The expectation is that interest rates will go up, and those expected increases are already priced in by the market. They are priced in because there is essential, publicly available information about the intentions of central banks with future interest rate movements.

5. The yield to maturity, and thus the expected return is much higher now

On a positive note, bonds are yielding more than in previous years. The Dimensional Global Bond Sustainability Trust, as of the date of writing, is paying 4.77 [1]. That number was closer to one percent 18 months ago. That means for investors that bonds now have a much higher expected return. Even if prices go down, investors could still earn a positive return because they start from a 4.77 percent yield rather than a one percent yield.

To summarise, over the next year:

• If yields do not change, investors win.
• If yields go down, investors win.
• If yields go up, prices will fall, but investors start from around a 4.77 percent[2] return rather than a one percent return. Therefore, they could still earn a net positive return over the next 12 months.

Conclusion

We understand that it has been a tough 12 months for bondholders as the RBNZ moves to fight inflation. Markets have moved quickly, as they should, to reflect this change. The way markets do that is through prices. So, while the returns over the past six months have been painful, they do make economic sense. Should bonds hold a long-term place in investors’ portfolios? The answer is yes. They remain a good diversifier, are issued by investment grade borrowers, interest rate increases are factored in, and yields are much higher than they were 18 months ago.

If you have any concerns, please let us know. As always, we want you to be comfortable with your long-term investment strategy.

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26 July 2022

Article provided by Consilium.

Disclaimer: Information as at 26 July 2022. This article is general information and does not consider your financial situation or goals and does not constitute personalised advice. Please contact your financial adviser for advice specific to your situation. There are no warranties, expressed or implied, regarding the accuracy or completeness of any information included as part of this article.