Understanding The Investment Cycle And The Place Of Bonds In A Balanced Investment Strategy
Posted on July 4, 2008
Filed Under Personal Finances |
In a life filled with risk, it pays to play it safe sometimes. In the past, investing with bonds been seen as a fairly pedestrian investment, but as part of a balanced portfolio, bonds have an important role to play. Today we discuss the value of bonds as a counter-cyclical balance for a stock portfolio.
Firstly, bear in mind that returns can be significantly improved by judiciously investing in corporate bonds. What are corporate bonds? They are the money raised by corporations over and above the sales, services, loans from banks and stocks. Unfortunately, not too many investors have taken the time and the effort to understand this instrument.
A bond is a loan to a company and like loans, there is a date when the loan has to be paid back and a rate of interest that has to be paid on that loan in the meantime. Bonds are usually with companies for 10 years, after which they reach their maturity date.
While they are relatively safe, bonds too have certain risk factors which we are going to look at. These can be classified under the terms Credit Risk, Interest Risk and Maturity Risk.
Credit Risk
There are defaulters where bonds are concerned, too and the entity issuing your bond may default. Unlikely if it’s Uncle Sam, but even AA rated corporate bonds have some credit risk.
Interest Risk
There is a fixed coupon rate or an interest rate attached to each bond – however, market rates may change depending on market factors.
Maturity Risk
There are some bonds that are allowed redemption before they mature. These are called being ‘callable’. So they can pay for the bond you hold with cash or issue new bonds against it or maybe even a bank loan. This means that if you have been used to getting a high rate of interest, this might suddenly stop if the company tends to call up the bond.
Because bond values are driven by different factors from stock and property values, bonds can provide a buffer against volatility in your investment portfolio. Studies have shown that holding between 20% and 40% of a stock portfolio in bonds can reduce the extent of negative movements (losses) across the overall portfolio, without a commensurate reduction in the average gain across the overall portfolio. That is, there is some loss of profits when things are going well, but that loss is smaller than the reduction in losses when things go bad.
If you buy bonds at issue and hold them until their maturity date, you have a relatively lower risk investment than if you try to get fancy. You must thoroughly understand the risks and rewards of investing in bonds rather than trying to make capital gains by trading in bonds before starting to trade in bonds. You can get significant benefit from holding bonds, however, as their value movements tend to offset large downward movements in the stock market. Corporate bonds pay significantly higher coupon rates, and some may even be convertible at attractive terms. The wise investor will always include investing in bonds in their investment strategy.
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