Many investors feel they should have bonds somewhere in their portfolios, but don't know how much they should allocate or whether to buy individual bonds or funds. They also struggle with some of the key concepts, and how long they should hold bonds for.
A smart allocation to bonds can make the difference between a portfolio with scary ups and downs that spook investors out of the stock market, leaving a retiree short of the money needed to pay bills, and a more stable and diversified portfolio that can deliver the outcome an investor needs.
1. Watch the Flipsides
Confusion often starts with the basic premise of bonds: bad economic news is generally good news for bond prices and vice versa. The recent popularity of bond funds can be put down to fears that the world economy is heading for a downturn, especially with the US-China trade war dragging on growth. If greed makes stocks go up and fear makes them go down, it is generally the opposite for bond prices.
In a time of crisis, investors are willing to pay more, and accept a lower yield, in exchange for the relative safety of bonds. Yet for an investor looking to invest in a bond fund for income, it can be good news when bond prices are falling and yields are rising. Falling bond prices mean rising yields and vice versa.
2. Bonds Are a Good Diversifier
One of the great features of holding bonds is diversification – they bring something different from equities to the table in terms of performance. For instance, during a steep stock market decline such as in the fourth quarter of 2018, government bonds tend to appreciate, serving as a valuable offset for any losses. While a seasoned long-term investor may well ride out the ups and downs in the markets, a well-diversified portfolio can help smooth out bumps on the way.
There's a fundamental reason for the diversification feature of bonds: when an investor or fund buys a bond, that bond issuer is promising to pay bondholders a stream of income in the form of interest (aka yield.) The value of that income contract typically acts as an anchor for the price of that bond, even during times of uncertainty.
Government bonds tend to be more protective of capital during market panic than corporate bonds, as evidenced during the last financial crisis. But corporate bonds often share some of the same risks as stocks, as some high-profile company collapses in recent years have shown.
3. Don't Use Rules of Thumb
Many UK financial advisers used to apply the 80/20 rule to investors' portfolios: 80% of the investments should be in equities and 20% in bonds before a client reaches retirement. As pension age approaches, the exposure to bonds increased. Indeed, many company pension funds are based on this strategy, with funds automatically switched to "safer assets" as the scheme member hits certain milestones such as 50 or 60 years old. But this depends on some outdated assumptions about life expectancy and what options an investor has to achieve diversification.
Vanguard founder Jack Bogle once said that your exposure to bonds should match your age, but these"one size fits all" approaches doesn't work for everyone. If you're unsure, it may be worthwhile seeing a financial adviser before making any asset allocation decisions, especially if your financial or risk profiles don't fit "ordinary" categories.
4. Don't Expect Miracles
Bond markets have enjoyed one of the greatest 30- to 40-year bull markets on record.
Bond yields have fallen from highs of more than 15% in the early 1980s to lows of around 1% today, but the asset class has delivered outsized returns by historical standards for investors on a risk-adjusted basis and overall basis.
That's been good news for bond investors, but that rally has left yields at historically low levels. Many government bond yields in the developed world are negative, which means investors are paying for the security of owning the asset.
Given the very long bull market for bonds, many bond investors have been eyeing the exit for a while, only to have some geopolitical news or other hiccup cast their plans into disarray. The Federal Reserve's about-turn over interest rates, with four interest rate rises in 2018 followed by three cuts this year, is an example of how investors often have to adjust their asset allocation decisions as circumstances change.
5. Be Patient and Flexible
The argument runs - if you want capital security, why not put your money in cash? After all, savings rates are now similar to bond yields - in some cases better - and bonds don't offer 100% capital security.
But cash yields have been so low in recent years that investors are losing purchasing power when factoring in the erosionary effects of inflation, which is currently running at 1.7% in the UK. In other words, cash loses its value over time.
So for investors who have a little more time - say, at least three years - a short- or medium-term bond fund can make more sense, even if rates are expected to rise. Another consideration is portfolio diversification. Cash won't lose money during an equity-market shock, nor will it gain. As discussed above, though, bonds can have a negative correlation with equities and can gain in price during stock market declines.
6. Trust the Professionals?
Building a portfolio of diversified stocks is relatively simple and cheap, but doing so with bonds can be more expensive and complicated.
Individual bond buyers, particularly those without a lot of money to invest, can face high trading costs when transacting in individual bonds, which can make a real dent in returns.
In contrast, bond fund managers assemble a broadly diversified portfolio of bonds for a low cost - corporate bonds, government bonds, and bonds backed by assets like mortgages-- thereby aiming to reduce the damage that any one holding can inflict on their overall portfolios.
The choice whether to go active or passive is a trickier one. The increasing popularity of passive investing, as well as several blows to the cult of the star manager, mean that active managers have to work harder to justify their fees. This year, Morningstar fund flow data has flagged up the popularity of bond trackers - for example, the ASI Global Corporate Bond Tracker saw some of the biggest inflows in September.
There are arguments on both sides: Morningstar columnist John Rekenthaler argues that the low cost of index funds gives them an advantage over active funds over the long term.
But bond investing arguably has more variables than stock investing: managers have to consider, among other factors, credit ratings, inflation, interest rates, economic growth, liquidity and even political turmoil. Professional bond investors can often be more responsive to market changes than retail investors, and that is a strong argument for choosing a collective scheme over building your own portolio.
