Bonds Bonds Bonds

Why is it important to include bonds in one's investment portfolio?

Bonds
Picture of Althea Spinozzi
Althea Spinozzi

Head of Fixed Income Strategy

Bonds play a critical role in a person's investment portfolio because:

  1. Bonds stability and income. Bonds are considered relatively stable investments compared to other asset classes, such as stocks or commodities. Bondholders receive a fixed stream of income through regular interest payments.
  2.  Bonds are good for diversifying risk. By including bonds in a portfolio alongside stocks and other assets, overall risk can be reduced. Bonds have historically shown lower volatility than stocks, which are more prone to market fluctuations.
  3. Bonds are a great instrument for preserving capital. They are less risky than stocks due to their guaranteed return of principal upon maturity. Because of this, they are helpful tools for preserving capital, especially for investors with a lower risk tolerance or those who want to safeguard their wealth.
  4. Bonds can be used as a risk management tool. Bonds are useful tools for protecting against possible losses in an investment portfolio. For instance, if an investor has a substantial amount of stocks and expects a market downturn, they can allocate some of their portfolios to bonds to reduce potential losses.

What are the defining features of a bond?

  • Sector. Bonds are financial instruments that can be issued by various institutions operating in different sectors. Some sectors include government, financial services, technology, healthcare, energy, and consumer goods. A bond's risk profile varies depending on its sector. Bonds issued by developed countries' governments are usually considered risk-free and are often used as a benchmark when determining the price of debt transactions in that country.
  • Maturity. Bonds are financial instruments that generate periodic interest payments for a certain period, known as the bond's maturity. At the end of the maturity period, the principal amount is repaid in full. Bonds can have a short-term, medium-term, or long-term maturity. The longer the bond's maturity period, the more sensitive it is to fluctuations in the interest rates.
  • Yield. The yield on a fixed-income instrument represents the return an investor receives from holding that instrument. It is expressed as a percentage and calculated by dividing the annual interest income by the price of the instrument. If an investor buys a bond at a certain yield, they lock in that return for the life of the bond.
  • Coupon. The fixed interest rate the bond issuer promises to pay to bondholders.
  • Seniority. In the event of bankruptcy or liquidation, fixed-income instruments' repayment is prioritized over equity securities. This means that bondholders have a greater claim on the issuer's assets in case of default. Bonds are ranked differently based on their seniority, ranging from first-lien lo—senior secured to junior subordinated. Generally, the lower the bond seniority, the higher the yield an investor receives.

What do I have to know before buying a bond?

  1. Bond prices are inversely correlated with rates.  If benchmark rates are rising, the price of a bond will fall and vice versa.
  2. Investors lock in their bonds’ returns at purchase. When buying a bond at a certain yield, an investor locks in a specific return for the life of the bond. However, the mark-to-market price of the bond will continue to fluctuate depending on market conditions. If yields rise, the value of the bonds in secondary markets will fall, however an investor will continue to receive the agreed coupon until the maturity of the bonds. If yields fall, the value of the bonds will rise, and an investor might decide to sell the bonds at a gain, to turn to other better opportunities.

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