Bonds provide investors with predictable cash flows, capital stability and portfolio diversification. Additionally, bonds, also referred to as fixed income, typically act as a defensive investment during periods of market volatility.

Determining the level of bonds to add to a portfolio will largely depend on the age of the investor. Younger investors have more time to ride out market downturns, creating a bias towards a higher weighting of growth assets like equities. Older investors will likely favour lower risk, defensive investments like bonds to ensure preservation of capital.

Age aside, a crucial element in a portfolio’s performance is how funds are allocated across diverse investments and within different asset classes. The reason is the performance of asset classes differ in changing economic environments. For instance, a large corporate collapse may cause a 20% fall in the share market but from a portfolio perspective that drop may be partly offset by better performance in the bond part of your portfolio, or in other assets like property or commodities. The aim is to achieve a well-balanced portfolio that can withstand market fluctuations and provide long term stability to overall portfolio returns.

When building a diversified portfolio, advanced investors will utilise the five main asset classes:

1. Shares (Stocks, ETF’s)
2. Property (Residential, commercial)
3. Fixed Income (Government, corporate and high-yield bonds)
4. Cash (Savings, term deposits)
5. Commodities (Physical holdings, futures contracts)

In this article we will focus on bonds.

Aside from cash, bonds are considered to carry the least risk of available asset classes. This is because regular income from interest payments (known as coupons), and the return of the initial capital invested, are built into the terms and conditions of the issue. The level of risk will vary between bonds.

Fixed rate and Floating rate bonds

There are two primary types of bonds. Fixed rate bonds have a pre-determined coupon rate for the life of the bond. If interest rates rise it will erode the real return of the bond, and it will also negatively impact the resale price of the bond. The reverse applies if interest rates fall.

The return on floating rate bonds rise and fall as interest rates change, much the same as a variable interest rate on a housing loan. Typically, you would consider a floating rate bond if you expect interest rates to rise, and a fixed rate bond if you expect interest rates to fall.

The benefits of bonds 

• Income Generation: Bonds provide a reliable and predictable source of income, particularly when compared to dividend-paying stocks that may vary according to earnings and economic circumstances.
• Defensive Investment: Bonds act as a shelter during periods of market stress. When equities underperform, bonds tend to outperform. During the global financial crisis, for example, bond returns were positive while the stock market in Australia had dropped 54% at its March 2009 low point.
• Diversification and Risk Mitigation: Bonds offer diversification. Australian investors tend to have concentrated portfolios, primarily in domestic shares and property.  By including bonds, investors lower the risk profile of an investment portfolio and achieve greater income security.

What influences bond prices

 When you buy a share in a company it is perpetual if the company remains solvent and listed on an exchange. In comparison, most bonds have a maturity date of between 1-10 years, at which point the company or government issuer returns your initially invested capital. However, you do not have to keep a bond till maturity, as similar to a share, you can sell bonds on an exchange, like the ASX or the over-the-counter (OTC) market.

Bond prices are influenced by several factors, including supply and demand dynamics, credit quality, proximity to maturity date, and interest rates. Political upheavals or changes in government policies can also affect bond values. Understanding these factors allows investors to make informed decisions about bond investments.

 What to consider when investing in bonds:

• Default risk: If an issuer has financial troubles and collapses or requires restructuring, it may default on interest payments or the repayment of the principal at maturity. Bonds issued by companies or governments with a lower credit rating have a greater likelihood of default. Credit rating agencies are independent organisations that assess the creditworthiness of bond issuers and assign credit ratings to its bonds. These ratings provide an indication of the issuer’s ability to meet its financial obligations and help investors evaluate the credit risk associated with a bond.
• Interest rate risk: Depending on the type of bond, a change in interest rates can have a negative or positive impact on the total return of a bond and its resale value.
• Liquidity risk: Some bonds may have low trading volumes or limited market participants, making it challenging to sell when desired.

Investor considerations:

Investors should consider their investment goals and time horizons. An investor who buys multiple 10-year bonds with a plan to hold them until maturity may get their desired returns from interest payments but must also consider the amount of time their capital is tied up for. By spreading the maturity dates of bond investments, not only do you receive regular income, but you also have capital returning more regularly, giving you greater redeployment opportunities to meet changing investment goals. You can of course sell a bond but from a strategic viewpoint it is better to manage the bond portion of your portfolio from a duration perspective.

Always make sure to give enough time to research and analyse individual bonds, assess credit quality, and understand the risks involved before making investment decisions.

When investing in bonds, a key determination is whether an investment in the bond will bring a greater return than holding cash in a savings account or term deposit. Like any investment, the higher the return, the greater the risk. Not all bonds are the same and some carry a higher risk. Refer to our article on ‘What is a bond’ for a break-down on the different types of bonds, like Corporate Bonds and High Yield Bonds.

The bond universe is huge. There is a lot of variety and options for investors to consider. While this may mean more research, it also means investors can tailor bond investments to suit their goals. Our NAB Investment Specialists are experts in the field, and always on hand to answer any queries you have.

Important Information

The information contained in this article is gathered from multiple sources believed to be reliable as of the end of September 2023 and is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. Before acting on this information, we recommend that you consider whether it is appropriate for your circumstances and that you seek independent legal, financial and taxation advice before acting on any of this information. ©2023 NAB Private Wealth is a division of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit Licence 230686.