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Bonds – Diversifying your Investment Portfolio
Diversity – no matter the size and scale of a portfolio or an investor’s level of experience, diversity in an investment portfolio is often the key to managing risk and long-term success in creating wealth. In the face of a global pandemic, share markets present volatility and uncertainty, not something investors typically look for. For those who are looking to broaden the scope of their investments and improve stability over time, bonds may be an attractive option. In this article, we’ll explore what a bond is, how they tend to perform in different market conditions, and what their broader impact could be on your overall investment portfolio.
Bonds – What Are They?
A bond is a fixed-income unit of debt that companies and governments issue to investors. In essence, an investor lends money to a company or government body, is issued with a bond, and then receives a regular fixed interest payment from the borrower. Upon maturity, the date for which is given upon issue, the principal amount is paid back to the investor in full unless the company defaults on the bond. The bonds can normally be sold on by the initial holder to other investors (i.e. does not have to hold it to maturity).
Bonds in Different Market Conditions
Bond portfolios perform differently depending on the prevailing market conditions at the time, but are historically not as volatile as shares. Generally speaking, high-quality bonds tend to perform well when share markets struggle, so losses in balanced portfolios are dampened. In times of economic uncertainty, also known as a “bear market”, the outlook for growth in the market is deteriorated, interest rates fall, and bond values rise. This is due in part to the uncertainty leading to market volatility and a tendency for investors to move away from high-risk assets into safer assets like bonds. As the performance of bonds improves, and share performance declines, the low or negative correlation between the two dampens losses in diversified investment portfolios. Note this increased level of protection in bear markets also has the effect of reducing potential returns during a “bull market” (i.e. during times of economic certainty and share growth, interest rates will likely be rising and can have a negative impact on Bond prices).
The Critical Role of Bonds in Your Portfolio
The lower average returns that bonds provide has left them open to scrutiny for a number of years, especially during periods where share returns are high and bond returns are near historic lows. The argument against bonds is that their low yields and low income can not only hinder overall returns within a diversified portfolio, but they also do not absorb enough impact when share values drop. What is worth remembering, though, is that economic uncertainty and the volatility that brings can happen quickly, and at any time – therefore maintaining bonds in your portfolio can still offer diversification to lessen the impact of those situations.
Investors with bond assets may also be able to take advantage of bear markets – when equities are selling off and their value is decreasing. Bonds can provide protection in a volatile market, but also provide funds to leverage when it’s time to buy.
As we kick off another year with uncertainty around the global economy and how the ongoing COVID-19 pandemic may impact markets, your investment strategy should be reviewed to ensure it is right for your current circumstances and goals for the future. With that in mind, there’s no better time to get in touch with the Wealth team at McKinley Plowman to undertake an investment review – you can reach us on 08 9301 2200 (Joondalup); 08 9361 3300 (Victoria Park); or via our website. We look forward to helping you create and maintain wealth through 2022 and beyond!
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