Investment inflows into bonds are on the rise, and it’s easy to understand why they make sense for income, capital growth and diversification.
Most investors invest because they want to earn a ‘good return’. But what is ‘good’, and how does this personal yet intangible metric differ from one investor to another?
For some, ‘good’ might be defined as the highest possible portfolio return regardless of the associated risk and, consequently, going all in with equities.
For others, it means holding cash – because peace of mind is paramount, and so accepting the possibility of lower average returns in exchange for lower volatility satisfies their own sense of ‘good’.
These definitions are unsatisfying, however, because they assume that investors only have a single goal for their portfolios – leading to an either/or mindset.
The comeback kid
But there’s an alternate option where ‘good’ includes elements of capital growth, income, and a degree of protection against market sell-offs. Enter 2023’s comeback kid – investment-grade bonds.
For those unfamiliar with how bonds feature in the above investment equation of capital growth, income and shock absorption, here’s how each element works.
Firstly, income. Bonds provide income by matching borrowers with lenders, providing a loan in exchange for interest – and in this regard they are akin to mortgages, credit cards and other forms of lending. The investor is effectively the lender and so earns the interest – providing their investment portfolio with income.
Currently offering income yields typically in the region of 4-5 per cent, with a risk profile that typically lies somewhere between equities and cash, this often-dismissed asset class could help achieve the alternate definition of ‘good’ outlined above.
Next, capital growth. Capital gain can occur because bonds are traded on financial markets– with the price of a bond typically moving inversely to movement in interest rates.
What this means is that should inflation abate or if the economy enters a recession, subsequent lower interest rates could lead to capital appreciation through higher prices.
This brings us to diversification. We’ve previously written about the diversification benefits bonds can bring to an investment portfolio and how they often act as a shock absorber for an investment portfolio when equity markets are falling.
An investor who currently has a bonds allocation would probably sleep better at night knowing that a portion of their portfolio is better protected against dips in the equity market and better placed to deliver a reasonable, regular income over the next while.
This might all sound theoretical but the numbers from the last 20 years prove that this alternate ‘good return’ theory holds water.
Vanguard’s analysis of the average 10-year annualised return of Australian equities and bonds showed that an all-equities portfolio experienced a maximum drawdown of nearly -50 per cent, versus a more manageable -27 per cent drawdown in a 60/40 equities/bonds portfolio.
And while there was a performance cost associated with this, with the diversified portfolio returning slightly less on average over the two decades, the general difference in returns averaged just 1 per cent.
Historical returns across this 20-year period show that bonds can deliver income, capital returns and diversification benefits at a manageable cost to total portfolio returns.
Adding bonds is easy
Ultimately, how much of a portfolio should be allocated to bonds depends on one’s investment goals, risk tolerance and time horizon.
But if an allocation to bonds can help achieve a version of ‘good’ that works for that investor, investors should know that adding exposure to bonds is as easy as adding cash and/or equities.
This includes access through diversified, low-cost mutual funds and exchange-traded funds (ETFs) which are readily available from brokerages or directly from fund issuers.
And just like equity funds, investors can further tailor their exposure by geography or sector.
While only a minority may argue that bonds never went out of style, even strident critics would concur that last year’s repricing of inflation and interest rates – and consequent lower bond prices now – mean that they should be firmly back on investors’ radars.
That bond markets are typically forward-looking and consequently may already be pricing in expectations of future inflation and interest rate hikes, only further adds to their appeal.
This means that the cost of diversification is now cheaper than ever, with income and possible capital gains on top.
If this definition of ‘good’ sounds good – perhaps it’s time to revisit bonds.
An iteration of this article was published in The Australian Financial Review
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