By Sterling Xie
“Portfolio diversification” is a word that is often thrown around among investors. While we are told it is used to balance our investment risk, we're never told what that truly means. In reality, it has different implementations. It could mean investing in a wide array of companies in different industries and different risk levels of stocks, but it could also mean investing in different types of investments or assets. One of the most stable of such investments is bonds.
What is a bond?
Bonds are like loans from larger entities to investors. They can be seen as an “I owe you” from a certain entity, whether it be the government or corporations, to you, the investor. These bonds have a defined return rate or interest rate determined by the borrower. Bonds generate income through a series of payments known as coupon payments. These are typically paid quarterly, bi-annually, or annually. Definitionally, coupon payments are the total amount of money an investor is paid in interest (or in addition to the principal) from the borrower. Interestingly, the full amount of the principal or initial investment is returned to the investor at maturity or the expiration of the bond.
How do I get a return from bonds?
Bonds can also be sold prior to their maturity date on secondary markets in a strategy known as investing for total return. Investors often take advantage of bond price inflation and offer their bonds for resale at higher prices in the expectation that the bond will grow in value.
How do bonds generally perform?
Bond values are affected by a variety of economic indicators. One of the most important factors that affect bond rates is inflation. This is generally more important for secondary markets because investors that wait until full maturity will nearly always be paid in full (if the bond’s borrower is stable and relatively risk-free like the US government). On secondary markets, however, when the inflation rate is higher than the coupon rate of the bond, the perceived value of the bond drops. On the other hand, when the inflation rate is lower than the coupon rate of the bond, the perceived value of the bond increases. Other factors that impact bond values are market conditions, credit ratings that analysts give the bonds, and the time till maturity on the bond.
Why are bonds good for diversification?
Investors include bonds in their portfolios because they are part of a defensive asset class. This means that they are less risky than other assets like stocks. The purpose of diversification is to diversify the risk levels of the assets that you invest in. Bonds can help lower this net risk value. As with the economic principle, bonds having lower risk also means they have lower returns on average. According to PIMCO, in an analysis from 1991-2017 of the average return of different investment types, equities were around 30-40% while bonds were only around 20%.
Why it might be strategic to invest in bonds now
As we face the potential of an economic downturn by the end of 2023, bonds might be the best investment, especially as we see a generally slowing stock market. Bond investors do particularly well during economic recessions and slowdowns because slower economic growth generally means lower inflation, making bonds more valuable. Because of the stability of the bond, while the stock market declines as the company’s profits are affected by an economic slowdown and consumers have less stock market confidence, bonds still remain resilient.
Why does this matter for personal finance?
Bonds are an important investment consideration if you’re looking for long-term stability and a nearly guaranteed return on your investments.