The importance of Bonds

What are bonds, exactly, and how do they work? Why do they play a key role in many portfolios (particularly retirement portfolios) and how might they feature in your own strategy?

You may have heard that UK government bonds (gilts) took a hit in late September following the (then) Chancellor’s “Mini-Budget”, which sent panic through the markets due to concerns about how proposed tax cuts would be funded. The Bank of England (BoE) then intervened after the British pound fell to an all-time low against the US dollar, with the former earmarking £65bn to buy long-dated UK government bonds to try to stabilise the markets. Many pension funds were affected during this time.

Yet what are bonds, exactly, and how do they work? Why do they play a key role in many portfolios (particularly retirement portfolios) and how might they feature in your own strategy?

What are bonds?

A bond is a type of loan between an investor and a borrower. The former lends money to a company (or government) on the promise of repayment with regular interest. For this reason, bonds typically fall into the category of “fixed-income securities” and are seen as less risky than other investments, such as shares, due to the higher certainty and predictability of future income payments. However, certain bonds are riskier than others. Lending to the UK government (by buying gilts), for instance, is generally seen as “low-risk” as the government has never missed a repayment. Lending to a government of an emerging economy, however, usually carries more risk of non-repayment; as does lending to a company with a lower credit rating (“junk” bonds). However, the latter may offer a higher interest rate to investors to compensate for the risk.

Why did the Bank of England intervene in the bond market?

After the government released its Mini-Budget in late September, institutional investors grew increasingly concerned about how tax cuts would be funded (e.g. abolishing the 45% additional rate, which was later reversed). They began selling UK government bonds in masse, driving down the price. A range of pension funds almost collapsed due to their high levels of investment in bonds, leaving many at risk of negative asset value. By intervening via its promise of buying £65bn in long-dated government bonds, the BoE staved off a potential financial crisis. This extraordinary event shows that bonds are not entirely risk-free.

Why are bonds important to a portfolio?

Despite the events in the autumn, bonds have historically been less volatile than equities (e.g. “growth” stocks). They can form a vital component of many portfolios. Firstly, they can be useful as part of an income strategy, since the frequent interest payments from bonds offer a steady income stream (perhaps alongside dividend-paying shares, cash and other assets). This can make bonds attractive to people in retirement, who are perhaps less focused on growing their portfolio and are more interested in preserving their wealth and using it to support their lifestyle. Secondly, the high predictability of bond payments can make them a useful store of wealth to achieve short-term goals. For example, if you plan on placing a mortgage deposit in two years’ time, then buying a fixed-rate bond could offer a higher interest rate than cash (e.g. 4.85%). Of course, this potential return needs to be weighed against the possibility of not getting back what you invested (due to default).

Thirdly, bonds can be a valuable diversification tool for investors. This is because bonds often have an inverse relationship with stocks. When the stock market falls, investors tend to “flee” to the “safety” of bonds - driving their prices up. If bonds fall in value (e.g. due to lower interest rates), then investors may be more inclined to seek higher potential returns from stocks. Therefore, an investor with a portfolio split between stocks and bonds (e.g. 50:50) is unlikely to see their portfolio fall as much as an entire stock market index (e.g. the S&P 500) during a “bear market”. This can help make short-term investment volatility easier to cope with for many people.

Where should bonds sit in a portfolio?

Now, you know what a bond is, deciding to include bonds in your portfolio - and, if so, how many - depends on a range of factors. Your goals are very important. For instance, is your main goal to minimise volatility in a portfolio and to generate a small income along the way? If so, then bonds could be a core part of your strategy. If, however, you want to build a retirement fund over many years, bonds are unlikely to have the same potential as other assets (e.g. shares) to generate returns.

Your time horizon is also a key factor. How long until you will need the money? If you have three years in front of you, then lower-volatility assets like bonds may be more important than shares. The latter could crash during your investment timeframe, leaving you little/no time to wait for a market recovery. However, a long investment horizon (e.g. forty years) gives a portfolio plenty of time to weather multiple bear markets and achieve long-term growth. This leads to another key factor - your risk tolerance. How much investment volatility, in practice, can you deal with? Here, it can help to work with a financial planner to ask you important questions, such as: “What would you do if your portfolio fell by 20% tomorrow?” If you know that you would face a strong temptation to sell and get out of the market, then it is better to choose a more “cautious” asset allocation with the potential for lower returns than risk this outcome (which could crystallise your losses).

Get in touch with your usual Punter Southall Aspire advisor to discuss your investment options.