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Why invest in bonds?

by Justin McCarthy | May 30, 2013

Bonds (and fixed income) should be a permanent feature of all investment portfolios. In particular, investors with a low appetite for risk and those nearing or in retirement should always have a healthy allocation to bonds to ensure their capital is safe and income is reliable. In many ways, bonds should be the anchor or foundation to which any investment portfolio is build around.

In addition to providing attractive returns, there are “four pillars” or key benefits to investing in bonds:

  • Capital stability: Or simply safety. Bondholders sit high in a company’s capital structure and have priority over equity holders in liquidation. As long as a bond issuer remains solvent, they must pay scheduled interest to the bondholder and repay principal upon maturity. As low risk investments, the capital price of bonds tends to be far less volatile that equities.
  • Cashflow: Regular and reliable income is the cornerstone of investing in bonds as they provide a known income stream through coupon (i.e. interest) payments. Investors can choose between fixed rate bonds, floating rate notes (FRN) and inflation linked bonds (ILB) depending on individual circumstances or market expectations. Fixed rate bonds provide the highest degree of certainty as they deliver a semi-annual payment that is fixed for the life of the bond. FRN and ILB typically pay quarterly coupon payments that do vary slightly depending on movements in interest rates and inflation. With a wide variety of bonds and payment types available, cashflows (and returns) can be tailored to suit any needs.
  • Liquidity: The over the counter (OTC) bond market is around five times larger than the global equity market and as such provides solid liquidity. Low risk, highly liquid fixed income investments like government bonds can be sold at very short notice if needed. Bank and corporate bonds are typically also liquid and easy to buy and sell.
  • Diversification: With a very large selection of bonds available, investors can enhance diversification in their investment portfolios. Moreover, bonds provide diversification from the two most highly cyclical asset classes, equities and property. In particular, fixed rate bonds provide a very valuable counter cyclical benefit to investment portfolios when equities are declining. Typically when an economy is struggling, equities fall in value and dividends tend to be reduced or cut entirely. This is generally matched with low growth and inflation. Regulators will try to stimulate the economy by cutting interest rates and this has the effect of increasing the value of fixed rate bonds due to their fixed, and now more valuable, income stream. This countercyclical buffer is extremely important for investors with a high weighting to equities. For example, in 2011, the ASX200 accumulation index fell 10.5% as the European debt crisis impacted confidence and growth. Over the same horizon an Australian Government bond paying a fixed coupon of 5.75% and maturing in 2021 provided a return of 20.2% (14.5% capital gain and the remainder from interest income) as interest rates and expectations were adjusted downwards.