Connections
Work with your personal adviser to grow your wealth

Defend and diversify with Bonds

Why bonds are critical in any portfolio

COVID-19 has had many ramifications, including an increase in the number and size of the government’s debt programmes. While these programmes assist people and businesses that are struggling, they also need to be funded – and this is where bonds come in.

Bonds are the way governments raise money. In the current environment, there’s strong demand for them – especially for the A-rated bonds – and for very good reasons. For example Government bonds are the most liquid assets around, and much less susceptible to market volatility than equities. They also provide certainty over how much income you’ll make over the life of the investment, which is an important confidence boost in uncertain times.

The role of bonds

Bonds are typically used as a defensive asset and to diversify against adverse moves in riskier assets, such as equities. While bonds pay lower levels of interest than riskier assets, they have a lower risk of not being repaid. Typically when risk markets are performing poorly or economic conditions are recessionary, investors can sell assets with uncertain cash flows (such as equities) in order to move into lower risk investments like bonds

Additionally, bonds can be used as both capital protection and an income generating security. Capital preservation comes from the fact that it’s less likely for bonds not to be repaid. In the case of a Government Bond it would require the government to default. In New Zealand the government has never defaulted on the interest payments on its issued bonds or on the repayment of principal.

On the income side, bonds pay periodic coupons, which in the case of corporate bonds are usually at a higher rate of interest than the cash rate of Government bonds, but a lower rate than riskier assets, such as equity dividends. This makes them a more stable source of income for investors.

What returns to expect

As the name of the asset class suggests—fixed income—the biggest component of returns over long periods of time will be the income that investors receive, as the capital amount paid at maturity (principal) does not change over time.

When a long-term investor buys a government or corporate bond, they will know in advance what they are set to receive. For example, if an investor were to buy $100 of a 5-year bond at par that pays a 2% coupon annually, they would receive $2 each year for five years and get $100 back at maturity. Regardless of what interest rates do over that 5-year period, the investor who holds to maturity has a degree of certainty around their expected return—in this example it’s ~2%.

Over the shorter term, however, bond returns are affected by interest rate movements. These interest rate movements will affect the capital price of holdings. The longer the time to maturity the greater the effect.

Here is a simple way to think about it. Imagine if an investor invested $100 for 10 years at 5% and the day after interest rates rose to 6%. In this scenario, they would receive $5 p.a. while the market is offering $6 p.a. If they tried to sell the security (which is offering $1 p.a. less than the market) they would need to do it at a discount to compensate the buyer for the interest they are giving up. This creates a capital loss.

 

The longer they had locked in that 5% rate, the more this would cost to exit. Chart 1 shows the estimated price change on different maturity government bonds for a 1% increase in yields.

Chart 1 – Estimated price change of a 1% increase in rates

 

Source: Bloomberg, Nikko AM

 

Alternatively, if rates fell to 4%, they would have a 5% coupon when the market is only offering 4%. In this case, if they were to sell they would receive a premium—a capital gain.

This is why it’s important to understand an investment horizon. Over short periods of time, bond returns can be relatively volatile. However, over longer periods of time the returns move closer to the yield offered on the securities.

Bonds are the most liquid asset

Looking forward, the key risk for bonds will be if interest rates rise quickly and for a prolonged period of time. For interest rates to be rising, it implies a strong economy that would potentially bring with it positive equity market returns. Chart 2 provides an example of how this typically plays out, showing the year-on-year return of both Australian government bonds and the ASX accumulation Index at the point in time when bonds had their worse performance in that year. Only in 1994 did both bonds and equities exhibit negative returns at the same time.

Chart 2 – Asset class returns during the worst periods for bonds

 

 

AM Source: Bloomberg, Nikko

Bonds are one of the most liquid assets in investment markets, allowing investors to buy and sell hundreds of millions of dollars in value at minimal cost. This is why bonds are used for raising cash as markets are sold off—they are more liquid and so less expensive to sell.

When thinking of liquidity from extremely liquid to extremely illiquid, at one end would be illiquid real assets such as real estate, which can take months to sell with large commissions involved. At the other extremely liquid end is government bonds, giving investors access to hundreds of millions of dollars in liquidity, which can take only seconds to execute.

 

Find An Adviser CONTACT NOW
Become A Client START NOW