Signs that bonds might bounce back
Fixed-income investments, commonly known as bonds, have traditionally served as a stabilizing force within investors’ portfolios, offering income, diversification from equity markets, and capital preservation. While the prolonged era of low interest rates has posed challenges for bonds over the past 15 years, there are indications that they are poised to reclaim a more significant role in multi-asset portfolios.
Against this backdrop, it's prudent for investors to revisit their understanding of bonds and their operational dynamics. While bonds may appear as simple loans on the surface, the intricacies and diversity beneath that simplicity are noteworthy.
Understanding Bonds:
At its core, a bond represents an agreement between a borrower and a lender. Borrowers typically include governments and companies seeking capital for various projects or expenses. Lenders encompass a wide range of entities, such as pension funds, endowments, individuals, corporations, and charitable organizations. The borrowing party issues bonds to raise funds from investors in the 'primary' market. A bond is characterized by several key elements:
Size: The amount the issuer aims to borrow.
Term: The duration for which the issuer intends to borrow.
Coupon: Regular payments made by the borrower to the lender.
Principal: The original amount repaid to the lender at the bond's maturity.
These elements, particularly the coupon, vary based on prevailing borrowing costs and the perceived riskiness of the borrower.
Types of Borrowers:
Developed Market Governments: Generally considered the safest borrowers due to their ability to generate income from taxpayers and control their currency. Bonds issued by developed market governments like US treasury bonds or UK gilts typically have lower coupons.
Emerging Market Governments: These governments can have more volatile economic and political environments, leading to higher-risk government bonds. They sometimes issue bonds in foreign currencies, introducing currency devaluation risk. Consequently, emerging market bonds often feature higher coupons.
Companies: Corporate bonds, issued by companies, usually offer higher coupons than government bonds due to the higher credit risk associated with companies. Corporate bonds vary widely in financial quality, with established businesses often enjoying more favorable terms.
Bond Ratings and Secondary Market:
Credit rating agencies like Moody’s and S&P assess the creditworthiness of bonds, categorizing them as 'investment grade' or 'high yield' based on risk. Bonds can be traded in the secondary market after issuance. The price of a bond in this market varies based on central bank interest rates, supply and demand, and changes in the issuer's creditworthiness.
Yield-to-Maturity (YTM) and Duration:
Yield-to-maturity represents the return an investor receives from a bond if held until maturity. It factors in coupon payments and capital gain/loss. Another concept, duration, gauges a bond’s price sensitivity to changes in interest rates. Longer-term bonds are more sensitive to interest rate changes due to the extended time until maturity.
Recent Bond Market History:
Bond markets experienced unique challenges after the Global Financial Crisis, with ultra-low interest rates resulting in negative yields for a significant portion of government bonds. However, 2022 saw a reversal as central banks raised rates to curb inflation, leading to bond yield increases and price declines.
Bonds' Role in a Portfolio:
Bonds historically provided income and diversification, acting as a buffer during equity market downturns. Low rates led to reduced bond income and increased correlation with stocks, eroding their diversification appeal. Nevertheless, with interest rates rising, bonds are regaining their role as income generators and diversifiers within portfolios.
In conclusion, bonds are making a comeback to their traditional role. Despite challenges posed by low rates, they continue to offer valuable attributes to investors, providing income, diversification, and stability within diversified portfolios.
Source: Evelyn Partners.
For personalized insights into how fixed-income investments and financial planning can benefit your portfolio, please contact us at info@waughmcdonald.co.ke.
