The role of fixed income in portfolios


  1. What role do bonds play in your portfolio?
  2. Bonds versus cash and term deposits
  3. The allocation decision

What role do bonds play in your portfolio?

Bonds have traditionally fulfilled four important roles in a portfolio:

Income stream
Most of the investment return for bonds is coupon income. For a broad portfolio of bonds, these coupon (or interest) payments can constitute a reliable stream of income. The chart below shows that in contrast to shares, which have historically provided income and capital appreciation, the total return for bonds has primarily been comprised of income.

Bonds

Capital preservation
Bonds can also provide capital stability. A bond’s principal is returned to you as the investor when it matures, which makes a bond an effective capital preservation tool, assuming of course that the issuer is of high credit quality. For example government bonds, which are backed by the full faith and credit of a sovereign government, are often referred to as risk-free because a government theoretically can raise taxes or create additional currency to meet its obligations when its bonds mature.

Store of liquidity
Bonds can be used as a store of liquidity. In fact, many central banks around the world exchange cash for bonds when they implement monetary policy and when they act to stabilise turbulent markets. Smaller investors are also able access this liquidity in a cost effective way through bond funds which usually allow you entry or exit on a daily basis.

Diversification of returns
Bonds can also help to reduce the risk in your portfolio by dampening the volatility of, and providing diversification to, share market returns. This is why bonds are described as a defensive asset. While the prices of bonds will fluctuate according to interest rate and economic cycles, they historically have been nowhere near as volatile as share prices.

We can see in the chart below, bonds returns have tended to be positive even when returns on shares have been negative. This is what analysts are referring to when they say there is a low or negative correlation between the returns of bond markets and share markets. It is this low or negative correlation between asset classes that provides the diversification every well balanced portfolio needs.

Calendar year returns for Australian shares and bonds


Bonds 

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Bonds versus cash and term deposits

Given their apparent similarities, many investors mistakenly consider cash and term deposits as a substitute or alternative to bonds. However, while these investments all offer features such as capital preservation, liquidity, and income, there are significant differences in their profiles.

Cash and term deposits can be better described as savings vehicles rather than an investment. They are better suited to help cover known short term liabilities or meet near term financial goals.

Investment in term deposits can also lead to reinvestment risk. That is, because your principal is fully returned to you at the end of each year you are exposed to any interest rate changes that have occurred in this time. This can have a substantial impact on your return the following year if attractive interest rates are no longer on offer.

In addition, if you are holding term deposits while you wait for the ‘ideal’ time to enter the share market this introduces liquidity risk. That is, there are generally penalty fees imposed if you need to quickly release your cash.

In contrast, bonds will offer higher expected returns over the long term for investors willing to take on slightly more risk. These higher returns are compensation for investors taking on increased levels of interest rate risk and credit risk exposure. In this sense, bonds generally suit an investor with a longer investment time horizon.

Bonds versus cash and term deposits

Investment type

Risk profile

Capital growth

Credit risk

Total return potential

Investment time horizon

Liquidity

Cash/Term deposits

Low

No

Lower

Lower

Up to 1 year

Varies. Term deposits are only accessible before term with penalty fees.

Bond funds

Low/Medium

Limited potential

Higher

Higher

3 year

High. Generally allow entry or exit on a daily basis.


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The allocation decision

So what is the correct level of bonds to include in your portfolio and how do you go about incorporating bonds into your asset mix to gain this exposure?

Any decisions on asset allocation should start by establishing goals, working out a timeframe (how long until you need to cash in your investment) and then evaluating your risk profile. Once you develop and execute your asset allocations, regular rebalancing helps to keep the portfolio on track.

Your risk profile relates to how comfortable or otherwise you are with levels of risk in the investment mix. Generally, the higher the expected return of an investment, the higher the risk, so on the spectrum cash follows bonds, follows property, follows shares. And generally risks are lessened the longer the investor's holding period.

If you consider yourself a conservative investor, a rule of thumb that Vanguard's founder, Jack Bogle, likes to cite to determine what the portfolio mix should be, is that the defensive allocation should be proportional to your age. For example, if you are 40 you should hold 40 per cent fixed-interest assets (therefore 60 per cent growth assets); at 60 you should have a 60/40 split between bonds and shares, and so on.

This approach may not be suitable for everyone, which is why a good financial adviser can add a lot of value by considering your overall financial situation and help to determine your propensity for risk.

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