In today’s markets, bond yields are low and those of high-quality bonds are the lowest.
In addition, they could quite feasibly crash too with interest rate rises.
So why have bonds in a portfolio?
It is quite straightforward.
Imagine you only hold equities with a portfolio of £200,000. The economy takes a turn for the worse, and the stock market drops by 25%. Your portfolio falls to £150,000.
It is a blow, but you believe you can handle it. You have seen bear markets before, and recoveries soon follow. However, the recovery does not come, markets fall another 35% and your portfolio is now worth £97,500.
At this point the economic news is horrible. Everyone believes it is only going to get worse is to come. Your plans have been set back years. Meanwhile, your industry is in trouble, and your job is threatened.
Your portfolio is your family’s safety net.
So, you panic and sell. Now you have locked in the loss and your portfolio really is worth £97,500.
Most longer-term investors own bonds in a portfolio to protect against large equity market falls. These, as shown above, could halve the value of their equity assets, or worse, in the short term.
High-quality bonds provide the best defense at these times as investors get nervous and scared money moves into ‘safer’ bond assets driving prices up. These tend to be bonds issued by strong governments and companies whose cost of borrowing is low and whose bonds are liquid.
But won’t I get poor returns from Bonds?
You should think of holding bonds as having an insurance policy with a high premium.
Investors can either pay the premium by owning bonds or self-insure, by riding out an equity market storm.
Every investor has a balance that makes sense for them. Trying to reduce the premium by higher-yielding bonds reduces the pay-out. This is because such bonds tend to act like equities just when you would not want them to. If you want to take on more risk to increase your returns, simply own more equities instead.
So what balance is right for me?
The markets do not dictate the balance between growth assets like equities and defensive assets in a clients portfolio. It is their goals and their situation that informs this. Key considerations are how much risk you are willing to take and how much risk you can afford to take.