What role do bonds play in a portfolio?
Since the evolution of the modern bond market, investors have used bonds as a way of diversifying their portfolio, generating income and preserving their capital. Some even use the bond market as a capital appreciation tool.
Since the evolution of the modern bond market, investors have used bonds as a way to diversify their portfolios, generate income and preserve capital. Some even use the bond market as a capital appreciation tool.
The Role of Bonds in a Portfolio
Investors include bonds in their investment portfolios for a range of reasons including income generation, capital preservation, capital appreciation and as a hedge against economic slowdown. In this section, we look at each in turn.
Bonds provide investors with a source of income in the form of coupon payments, which are typically paid quarterly, twice yearly or annually. The investor can use the income generated by their investments for spending or reinvestment. Shares also provide income in the form of dividends: however, such payments are less certain and tend to be less than bond coupons.
Unlike stocks, the principal value of a bond is returned to the investor in full at maturity. This can make bonds attractive to risk-averse investors who are concerned about losing their capital.
Although bonds are often viewed as a capital preservation tool, they also offer opportunities for capital appreciation. This occurs when investors take advantage of rising bond prices by selling their holdings prior to maturity on the secondary market. This is often referred to as investing for total return and is one of the more popular bond investment strategies.
Hedge against economic slowdown
While investors in stocks typically do not welcome a slowdown in economic growth, it can be a good thing for bond investors. This is because a slower growth usually leads to lower inflation, which makes bond income more attractive. An economic slowdown may also be negative for company profits and stock market returns, adding to the attractiveness of bond income during such a time.
View our case study focusing on volatility in the bond market and the role of bonds in a growth portfolio.
View case study
Diversifying with Bonds
Bonds are considered a defensive asset class because they are typically less volatile than some other asset classes such as stocks. Many investors include bonds in their portfolio as a source of diversification to help reduce volatility and overall portfolio risk.
The chart below shows the historical volatility of different asset classes – including bonds and stocks – over recent decades. The bars above the horizon (zero line) show gains, while bars below the horizon reflect losses. You can see from the chart that bonds have a different return profile than stocks, offering the potential for greater stability of returns.