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Why Own Bonds?

Before answering the question posed, it may perhaps be better to first establish exactly what a bond is.  In simple terms, a bond is nothing more than an IOU, a debt security under which the issuer owes the holders a debt and (depending on the terms of the bond) is obliged to pay them interest throughout the bond’s duration and to repay the investors’ capital at the maturity date.  They are issued by countries (government bonds) and by companies (corporate bonds) with interest payable at fixed intervals, hence their alternative title of Fixed Interest or Fixed Income Securities.  Bonds are also negotiable, i.e. the ownership of the instrument can also be bought and sold in the secondary market.  This means that although a return of capital is guaranteed, this only applies if the bond is held to maturity, so capital values can fluctuate.

As an asset class however, Fixed Income is generally considered to be a more stable, dependable investment option compared to other asset classes e.g. Equities (stocks & shares), as capital is guaranteed to be repaid at maturity unless the issuer of the bond defaults (highly unlikely with government bonds) and interest payments to the holder are also fixed and guaranteed throughout the lifetime of the security, which can be short, medium or long-dated.   However, central bank policies in recent times, including low interest rates, have driven returns from areas of Fixed Income such as government bonds to record lows.   In addition, over the long haul it is an inescapable fact that bonds tend to return much less than Equities, which tend to out-perform every other asset class, given sufficient time.

Why then should investors own bonds and why do we include them in the majority of our model investment portfolios?

The answer is two-fold.  It would seem obvious that when investing client money where the principal factor is the attainment of capital growth, our over-riding objective would be to maximise investment returns, so why create potential performance drag by including Fixed Income?  The answer is that whilst the basic objective of achieving capital growth makes sense, there is also the equally important caveat of achieving our investors’ objective within ‘acceptable risk parameters’.  Whilst it remains likely that, over time, Equities will continue to out-perform every other asset class, the attendant short-term volatility inherent within Equities as an asset class is not for everyone and investors with a more cautious approach may prefer to eschew the spectacular for a more a more steady and measured approach, even in the longer term.

The far better reason for owning bonds for most people however, is to diversify a portfolio.  Simply put, Bonds tend to zig when Equities zag, and vice versa.  The key to truly successful investing is to have several different asset classes - different investment components with different characteristics - all of which can be expected to deliver positive long-term returns but that do not all move up and down together at the same time during different investment cycles.  For this reason our Cautious portfolio will have a higher weighting in Fixed Income with a lower Equity exposure and, at the opposite end of the scale, our Adventurous portfolio will tilt largely, if not entirely, towards both UK and international Equities with minimal, if any, exposure to bonds.  The long term results when back-tested, speak for themselves with the portfolios with greater equity exposure delivering the best returns but for investors who cannot live with total exposure to the ‘blood & thunder’ of the stock market, there is undoubtedly a place in their portfolio for bonds.

This entry was posted on November 5, 2019