What bonds do in a portfolio

Bonds are the least well understood major asset class among retail investors, largely because their behaviour is counterintuitive.

What a bond is

A loan to a government or company, with defined interest payments and a repayment date.

Held to maturity by the original purchaser, the return is known in advance, absent default.

Traded before maturity, the price varies with interest rates, credit perception and time remaining.

Most investors hold bonds through funds rather than individually, which means they experience the price behaviour rather than the hold-to-maturity certainty.

The price and yield relationship

The point that causes most confusion.

When interest rates rise, the prices of existing bonds fall, because newly issued bonds offer higher payments and existing ones must become cheaper to compete.

When rates fall, existing bond prices rise.

Which means bond funds can and do lose value, sometimes substantially — as several major bond markets demonstrated during recent periods of rising rates, producing losses that surprised investors who believed bonds were safe.

Duration

The measure that determines sensitivity.

Duration approximates how much a bond's price moves for a given change in interest rates.

Longer duration means greater sensitivity: a long-dated bond fund can move substantially with rate changes, while a short-dated one moves considerably less.

Which means the choice between short, intermediate and long duration is a significant decision rather than a technicality.

Matching duration approximately to your time horizon is one framework; holding shorter duration for stability is another.

Credit quality

The other main dimension.

Government bonds of stable, high-quality issuers carry low default risk and are what provide diversification against equity falls.

Investment-grade corporate bonds carry more credit risk and pay more.

High-yield bonds carry considerably more, and historically behave more like equities during stress — which means they do not provide the diversification that people holding them for that purpose expect.

Emerging market debt has its own risks including currency.

Which means the reason for holding bonds determines what kind to hold.

Why hold them at all

Three distinct reasons.

Diversification: high-quality government bonds have historically tended to hold value or rise during equity falls, providing ballast.

This relationship is not reliable in all environments — notably when inflation drives both markets down simultaneously — which is a genuine limitation.

Income, which matters for investors drawing on the portfolio.

Volatility reduction, which allows an investor to hold a portfolio through periods they would otherwise sell out of — which is a behavioural function with real value.

The reason determines the type: diversification argues for high-quality government bonds, income may argue for corporate.

Inflation-linked bonds

A distinct instrument.

Payments and principal adjust with a measure of inflation, which provides protection against unexpected inflation that conventional bonds do not.

They still carry duration risk, which means they can fall when real interest rates rise, and this surprises holders who expected inflation protection to mean price stability.

They are useful for investors with long-dated real liabilities, and they are not a substitute for cash.

Currency

An important detail.

Foreign bonds introduce currency risk, which can dominate the bond's own return and which is generally larger than the return being sought.

Which is why hedging currency risk back to your own currency is common practice for bond holdings, and why unhedged foreign bond funds behave differently from what people expect.

For equities the argument is more balanced, since currency is a smaller proportion of the total volatility.

Bonds versus cash

A question that recurs.

Cash has no duration risk and no credit risk within deposit protection limits, and offers no capital appreciation.

Short-dated bonds behave similarly to cash with slightly more yield and slightly more risk.

Longer bonds offer more potential diversification benefit and more volatility.

Which means that in some rate environments cash is a reasonable substitute for the stability portion of a portfolio, and in others it is not — and that neither is a permanent answer.

The practical position

For most investors.

Bonds held through a broadly diversified, high-quality, currency-hedged fund, at a duration appropriate to the horizon.

Held for diversification and volatility reduction rather than for return.

In a proportion determined by capacity and tolerance for loss.

Rebalanced periodically.

And understood as an asset that can fall in value, since the alternative is selling them at the point where they are doing least well.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.