Bond Investment Strategies
Your Bond Investment and Turbulent Markets
Financial markets are never still. They can appear calm and comforting one day only to have an unexpected event upset the balance and send things into a tailspin. Building a portfolio for savings and eventual retirement involves thinking about the mix of investments you employ to achieve your goals regardless of what happens.
Owning shares is often and rightly touted as a key way to increase the value of your savings by sharing in the success of companies at home and abroad. Owning equity shares either directly or through a mutual fund or unit trust positions investors to see the value of their shares grow with the fortunes of the company that issued them.
Share prices rise when the market believes the economy is expanding, or when a particular sector (energy companies or computer makers or retail clothing, for instance) is in a growth phase or when an individual company reveals a plan or product that analysts and investors believe shows great promise for success. But, as is well known, share prices that soar high can also decline dramatically, without warning. Products or services once in demand can quickly fall out of favour. Booms can turn to busts, and when that happens share value declines and investors lose money.
Where shares are the way to grow wealth, bond instruments can preserve capital, generate interest income, help save money for a future point in time, and stabilise the overall performance of an investment portfolio that includes shares, which are by nature more volatile in price than bonds.
Unlike shares, which represent an ownership share or equity in the issuing company, bonds are loans from the bond investor to the bond issuer. The issuer promises to repay the bondholder the amount borrowed, or principal, at a specific future date, the maturity or redemption date. The issuer further promises to pay the bondholder interest at a defined annual rate until then. If you have a bond, (one issued by a EU government for instance) in your portfolio, the interest, which in this case is guaranteed by the government, will continue to flow into your account regardless of what is happening with share prices.
Bonds can therefore be seen as a backstop against downward equity market pressures. Furthermore, when economies falter, bond prices often rise when share prices are falling as investors move their money from a greater perceived risk of owning equity than to the risk of owning a bond or bond fund.
Government bonds issued by some EU members, the UK and the US are generally considered the safest bond investments to hold because these governments, which have generally strong economies and long histories of honouring their commitments, guarantee them. The governments can also raise taxes, if needed, to pay their debts. During periods of market turbulence, bonds that are highly rated by the agencies that assess the bond issuer’s ability to meet its obligations to bondholders are considered a comparatively safer investment. With bonds as with other investments, however, the return potential increases with the risk. Because these bonds are so safe, the coupon interest is usually the lowest, on a relative basis, reflecting the low risk. While government bonds can be a great way to secure your money, having too many government bonds in your account could mean you do not receive as much investment return as you might like or need.
If the market is lacking predictability and turbulence is including lower share prices, investors wanting to bring predictability and protection to a portfolio—and purchase a stable cash flow against the decline of share prices-- may also consider investments in highly rated corporate bonds. Borrowing money by issuing bonds is an alternative to issuing shares for companies who want to expand operations or devote more funds to research and development. Corporate bonds usually pay more interest than government bonds because the government does not guarantee them. The key to looking at corporate bonds is to check their credit ratings, with “AAA” (or “Aaa”) being the highest rating offered by agencies such as Standard & Poors (or Moody’s). As with government bonds, highly rated corporate bonds should keep paying interest for the life of the bond regardless of the performance of the issuing companies’ share price.
Every bond comes with a price that fluctuates in response to market conditions and key interest rates established by central banks (see “Reading the Financial Pages”). If the rates rise above a bond’s interest rate (coupon), its market value will be lower. Conversely, a bond will be worth more if rates fall below its coupon rate. However, bonds usually trade in narrower price ranges than shares, another reason they can possess protective qualities in difficult times.
Choosing among investments is ultimately a matter of personal choice. The proper asset allocation or the percentage of shares, bonds or cash you might hold at any one time depends upon your perceived need and your tolerance for enduring whatever level of risk you take on. Before proceeding with any investment it is of course important to learn as much you can about how they work and what the risks are.
- Be clear and know why you have the bonds or bond funds you do, i.e. whether the primary purpose of the investment is providing income, preserving your capital or giving you total return. That way you are not always reacting to someone else’s nerves or news. Human emotions are not the most reliable indicator of what is the right thing to do in a volatile market. Stay clear on your objectives and change strategy only if your goals change or your personal circumstances change.
- Make sure you understand the risk of the bonds or bond funds you are investing in. Take advice if you need to in order to understand what the reasons are for the yield you are being promised. High yields in some funds may be tempting but remember that more yield usually comes with more risk. Know the risks of the investments you have. Make sure if you are comfortable with the risk that you are receiving return that compensates you for taking it. As always consult with a financial advisor.
- Take a longer term perspective and resist being reactive. Research on European individual investors suggests that individuals who take too short a term perspective or react by trying to “time” the market lose a lot of value in their portfolios. Getting in and pulling out of funds at the wrong times makes long term gains less likely.