Have you ever gotten a hot tip on a bond? Probably not.
Bonds don't make the most exciting dinner table conversation, but they are in fact the largest securities market in the world.
Global fixed income market is about US$133 trillion in size, in the US alone there are more than 80,000 bond instruments outstanding, vs only 58,200 listed equities globally. It is larger than all of the global stock exchanges combined, and even larger than the total world GDP (World Bank estimated this to be $101 trillion in 2022).
Maybe we shy away from bonds because it is not as easy to understand, or there is less excitement compared to equities or cryptocurrencies. But they certainly have a role in your investment portfolio.
What are Bonds?
A bond is simply a loan to a company (or any entity) that requires money.
As an example: "I will lend Marvel Co. $100,000 and Marvel Co. will pay me $5,000 per year (periodic interest payment) until they pay back the $100,000 (principal amount) ten years (tenor) from now."
As an investor, you then receive periodic interest payments, and derive a regular and predictable income from it.
Role of bonds in portfolio allocation
Adding bonds into your investment portfolio diversifies your assets and smooths out returns over the long-term. In most cases, stocks and bonds have low or negative correlation, which means that their prices tend to not move in the same direction or with the same magnitude.
Acting as a counterweight to equity market movements
Historically, outside of periods of high inflation bonds and stocks generally exhibit negative correlation, looking at data since the 2000. In the last 20 bear markets in the US since 1928 when the S&P 500 declined by 20% or more, the average return from long-term government bonds was a positive 5% and the median return was also a positive 3.2%. (Source: Bloomberg). As inflation begins to peak and the Fed approaches the end of its tightening cycle, bonds’ role as a hedge to equities is likely to resume again.
Lowering investment portfolio's volatility
Bonds have historically been less volatile than stocks, thanks to where they sit in a company's capital structure. Bonds are senior to stocks in that bondholders have to be paid back in full before stockholders get a cent if a company were to go belly-up.
As a result, bond prices tend to fluctuate less than equities, and can potentially help to lower the overall volatility of your investment portfolio.
US investment grade corporate bonds have never had more than two rolling years of consecutive negative returns. This is why it may make sense to consider increasing your bond allocation as you get closer to your investment goal or retirement.
However, its low volatility nature does not mean bond investment returns are capped. When bonds are undervalued or if interest rates fall (which seems to be the current market consensus for 2024), bond prices could have significant moves - as it drives market prices of bonds which contribute to total returns of your bond investments
Understanding your risk profile matters in choosing the right bond allocation
Monitoring your bond portfolio can seem as thrilling as watching grass grow, whereas watching stocks is like the end of the Korea vs Germany game at the World Cup, especially during periods when stocks are giving you double digit returns.
However, everyone has a different risk appetite, and it's important that you only take as much risk as you need or are willing to bear. You will only stick to your investment plan if you can stomach the volatility of your portfolio through market cycles.
So rather than avoiding bonds altogether, you should instead assess your risk tolerance and investment goals, and decide how much of your portfolio should be allocated to bonds and what kind of bonds are beneficial to your portfolio.
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Risk Warnings
Investment involves risk. Past performance is not an indicator nor a guarantee of future performance. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested.
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