Adding bonds to your portfolio: why and how? Adding bonds to your portfolio: why and how? Adding bonds to your portfolio: why and how?

Adding bonds to your portfolio: why and how?

Bonds 15 minutes to read
Saxo

Summary:  This article offers perspective on the opportunities and risks that bond investments can bring to your portfolio. Bonds come in all shapes and sizes in terms of maturity horizon and risk levels and offer diversification benefits relative to a heavily stock-weighted portfolio. Particularly for those looking for steady income-like returns that haven’t been available to most investors, particularly in Europe, since the global financial crisis, bonds are worth consideration. Saxo clients have quick and easy access to an enormous variety of bonds on Saxo’s platform.


Level: Starter


Adding bonds to your portfolio: why and how?

This article is for anyone that is relatively new to the world of bonds and is considering allocating some of their account or portfolio to bonds, whether for:

  • Earning higher returns on idle cash or deposits
  • Diversifying some percentage of your portfolio with bonds of varying risk levels.

It should be noted that professional investors can use bonds as collateral for margin trading (up to 95% for the highest rated bonds). In all cases below, we only discuss bonds that mature in the 1-2 year time horizon as the safest place to operate in this market environment, given that shorter bonds offer the highest yields available at present and that central banks have yet to prove that they are winning their battle against inflation (i.e., bond yields could go higher still in the months and years to come if central banks have to hike rates even more than expected presently).

This article will offer:

  • Perspective on the general yield levels that bonds can offer (as of early March 2023), from government securities widely considered to be “risk free” (more below) to low-risk investment grade corporate bonds and higher-risk high yield corporate bonds.
  • A very brief introduction to the world of bonds.
  • A few examples of what specific types of bonds are worth adding, depending on risk tolerance.
  • For inspiration, one commonly used model to calculate the percentage of your portfolio that should be in bonds relative to your age and intended retirement date.
  • How to trade bonds in Saxo’s platform.

For a more exhaustive primer on the world of trading and investing in bonds, have a look at bond-investing giant PIMCO’s guide.

What kind of returns can you expect from 1-2 year bonds?

The indications below for the yields available from shorter term bonds will fluctuate with market conditions and do not include transactions costs, which will depend on the size of the transaction and the liquidity of the bond in question (minimal costs for the most liquid instruments). By the way, in the month of February 2023, the US 2-year treasury yield rose approximately 0.60% and the German 2-year yield rose about 0.45%, to get a sense of how rapidly yields are moving during the recent time frame.

Note: all yields below are a snapshot made near March 1 of 2023 and subject to change as the market fluctuates.

1-2 year yields for USD-based investors

  • US Treasuries: 4.8+% for a 2-year US Treasury
  • Investment Grade US corporate bonds: approximately 5.25-5.50%
  • High yield bonds:  6% and higher, depending on risk tolerance.
  • Floating rate bonds: currently (as of March 2023) yield slightly less than 1-2 year bonds, but if central banks continue to hike as expected, the yield will move higher.

1-2 year yields for EUR-based investors

  • “Risk-free” core EU bonds (Germany, France, etc..):  3.1% for 2-yr bonds
  • Italian government bonds, or BTPs: 3.5% for 2-yr bonds
  • Investment Grade EU corporate bonds: approximately 3.5%.
  • High-yield EU debt: 4% and up, depending on risk tolerance.
  • Floating rate bonds: currently (as of March 2023) yield slightly less than 1-2 year bonds, but if central banks continue to hike as expected, the yield will move higher from current levels.

1-2 year yields for DKK-based investors

  • Danish government bonds:  near 3.2% for 1-2 year bonds
  • Danish mortgage bonds: about 3.5%

What are bonds? A very brief introduction.

Bonds are a class of debt securities issued by governments and companies that typically pay out a pre-defined cash flow to holders, called its “coupon”. On their date of issuance, the vast majority of bonds have a maturity date, a date in the future when the bond holder will be reimbursed the full face amount of the bond. That face amount at maturity is called par and is expressed at a price of 100 for the bond, i.e., 100% of the face amount. A bond can trade both well above par and well below par depending on a number of factors, like the size and of its coupon relative to prevailing interest rates, the timing of the coupon payout, and the credit quality of the government or company issuing the bond and other factors.

There are an endless variety of bonds, for example those with coupons that “float” according to changes in the interest rates, inflation-linked bonds, short term bills that are issued below par and don’t pay a coupon, but mature at par, etc. It can all seem a bit daunting to investors not familiar with bonds, or “fixed income” as the professionals call them. But complexity shouldn’t scare investors away from investing in bonds. The vast majority of bonds worth buying for an investor looking for basic income and portfolio diversification, especially those with a medium or higher credit ratings, are quite straightforward in their risk- versus expected return profile. That is especially the case in the current environment of significantly positive interest rates, i.e., now that we have exited the zero- and negative policy rate era in most countries.

So you want to add bonds to your portfolio. What next?

–> Understand the risks

Short-term government bonds and bills (basically a short-term version of a government bond with special characteristics as described at the bottom of this section) are often termed “risk-less” as a default is considered largely inconceivable, but that doesn’t mean there is no risk in buying even government bonds.

Credit risk: The credit risk is simply the risk that the bond issuer fails an interest rate payment or to redeem the bond at face value at maturity. There is no real credit risk for sovereign debt that is issued in the currency of the sovereign. (Important to note the theoretical exception of all EU countries in the Monetary Union, especially the non-core, or “peripheral” Eurozone countries like Italy and Greece, as discussed below, as EU countries in the monetary union don’t have their own central bank and are in theory more at risk than debt issued directly by the EU itself.) There is a far more significant credit risk for countries issuing debt in a currency other than their own, for example in emerging markets, and for company-issued debt/bonds. Credit risk for companies is of considerable importance and can be considered very low or very high, depending on the strength of the company balance sheet in question. Yield levels relative to the lowest risk debt in a given currency usually reflect the level of credit risk for a company or country. There is also seniority to consider, as not only are debt holders paid in the event of a bankruptcy and liquidation before equity holders, but companies may have two or more levels of seniority in their debt structure, under which the most senior debt is paid first before more junior tranches of debt.

Interest rate risk: This is the risk that the interest rate rises after the purchase of the bond or bill and the market value of the bond falls, which could result in a capital loss if sold. For example, if you buy a German government bond with 1-year left until maturity at a yield of 3.00% and the 1-year German yield rises another 2% over the next three months, your bond would be worth about 0.7% less as a buyer can only be found for that bond if it yields an annualized 5% until the maturity date, assuming yields are the same for 9-months and 1-year. If held to maturity, the bond would still be redeemed at par, or 100% of the face value, but you would have earned more had you waited to buy the 1-year-to-maturity bond at the higher interest rate.

The longer the maturity, the more the market value is affected by interest rate risk. The opposite is the case if interest rates fall after you purchase a bond, which benefits the value of your position between the time of purchase and the maturity date and offers the opportunity to take profit and invest the funds elsewhere. Given that as of this writing in early March 2023, the highest yields available are at the short-end of the yield curve (with maturities of less than two years), most will want to lock in these yields rather than taking risks that yields continue to rise, especially longer yields. Of course, if longer yields collapse, for example because the world suddenly careens into a recession and disinflation investors would have missed out on the strong rebound in bond prices as yields fall, with the best returns for the longest bonds.

Inflation risk: This is the risk that inflation rises and impacts the real return of the bond investment, which is the return less the inflation rate. With inflation running very hot over the last year and more, most real returns on bonds have been negative, though if inflation falls back sufficiently in the coming six months, bonds’ real returns may soon return to positive territory (Current medium and longer term inflation expectations are lower than bond yields, but there is a risk that inflation stays high).. If inflation rises after the date of purchase, the real return of the bond will fall.

Liquidity risk: This is the risk that it is difficult and/or expensive to find a buyer of the bond an investor holds. This is mostly a non-issue for extremely liquid government bonds and bills, but becomes a more significant issue for riskier bonds and illiquid bonds that rarely trade. The bond’s liquidity risk is generally reflected in the width of the bid-offer spread when trading the bond, especially if you both buy and eventually sell the bond position rather than holding to maturity.

Currency risk: Currency risk is entirely avoidable for investors sticking to bonds issued in their own currency, but it can be a very significant two-way risk when buying bonds in another currency. Currency fluctuations will often prove far more volatile than the return on a bond, so currency risk should generally be avoided unless the investor has a view on the currency of the bond – not the intention here. Yes, currency exposure can be hedged in the currency market, and rather cheaply if the yields are similar between the home currency and the currency of the bond of interest, but can be very expensive when the yield in the currency of the target bond is significantly higher. As of this writing, for example, a Japanese investor buying a US treasury will lock in a slightly negative return on 1-year US treasuries (the generic term for US debt) in JPY terms if hedging the entire currency exposure and holding the treasury until maturity.

Call risk: Some bonds (mostly corporate bonds, but some floating rate bonds issued by governments have callable and/or “sinkable” features under which at regularly scheduled times, the bond issuer can call away the bond at par for callable bonds or buy it back at prevailing market prices if it is sinkable.

–> Decide on percentage of funds to allocate and choose an investment horizon.

First, decide what percentage of your funds you would like to shift into bonds and then decide on the intended time horizon(s) of the allocation to bonds. In the current environment of so-called inverted yield curves, for which high central bank policy rates relative to longer term bond yields, there for staying at the shorter end of the investment horizon, quite the contrary, as many central banks are expected to soon stop hiking rates and even begin cutting rates as soon as early next year (as of this writing). If making a more significant decision on the percentage of your portfolio to allocate to bonds on a longer term basis beyond the next year or two, or if making any significant investment decision, consult a professional investment adviser. One “rule of thumb” allocation model is in the appendix below as food for thought.

–> Determine which bonds to buy.

What to buy if only considering the lowest-risk bonds

To earn income on idle cash/un-invested funds: Investors can choose very low risk government bonds that mature in 1-2 years, or even buy some 3-6 month bills* if convinced that interest rates may rise further still and then reinvesting the funds at maturity, while leaning more toward 2-year bonds if convinced that interest rates may cool over that time frame.


USD investors
: 1-2 year US Treasuries or T-bills*

EUR investors: 1-2 year core EU bonds (Germany, Netherlands, France, etc)

GBP investors: 1-2 year Gilts (UK Government bonds)

DKK investors: 1-2 year Danish Government bonds, 1-2 year Danish Mortgage Bonds

The table below offers specific ISIN numbers for shorter maturity government bonds and for Denmark, Danish Mortgage bonds, from those maturing in approximately six months to up to three years, depending on your currency region. Further below you can find links for instruction on how to find and trade these specific bonds in Saxo’s platforms - the easiest way is to simply copy and paste the ISIN number for the bond into the Instrument Search box in your Saxo platform.

CurrencyIssuer6 Months 1 Year 18 Months 2 Years 
USDUSA US9128285D82  US91282CEG24  US9128284F40
 EUR
Germany 

Netherlands 

France 
DE0001030872 

 NL0010418810

 FR0127613471
 DE0001102333

NL0012650469 

 FR0127613505
NL0010733424  DE0001102374

 NL0011220108

 FR0014007TY9
GBPUK  GB00B7Z53659 GB00BFWFPL34  GB00BK5CVX03
AUDAustralia   AU3TB0000143  AU3TB0000168
 DKKMortgage bonds  DK0002041029 DK0009295149 DK0002043744DK0009295222 
*Bills and T-bills: See the appendix below on the difference between a bill and a bond – the end result in yield terms is effectively the same as a standard coupon bond. Somewhat confusingly, the world’s most liquid bonds, US government bonds, are called treasuries, or Treasury Notes/T-notes when issued for 2-20 year maturities, Treasury Bonds/T-Bonds for the longest, 30-year maturity and Treasury bills/ T-bills for maturities of one year or less.

What to buy if considering slightly higher yielding, but “investment grade” bonds.

Those willing to take slightly more risk in order to achieve somewhat higher yields can consider corporate bonds of investment grade, which offer higher returns than less risky government securities, although the very highest rated corporate bonds, like USD bonds from Apple, hardly yield more than US treasuries.  Corporate debt is available from an enormous variety of companies of varying financial solidity. The term investment grade refers to corporate bonds that have been given a credit rating above a certain level by the main bond ratings agencies like Moody’s and S&P, depending on the issuer's perceived credit risk. There is a generally sliding scale from the lowest yielding, top-rated "AAA" rated corporate bonds down to the somewhat higher yielding, lower-rated (but still investment grade) corporates. The bonds rating agencies call anything below investment grade a high yield bond. Sometimes there is a significant drop in a bond’s value if the bond is ranked at the very lowest investment grade level and is placed on "negative watch" for a further downgrade or actually downgraded by any of the major bond ratings agencies. This is because many large bond funds are not allowed to hold bonds that are not designated investment grade. A rough illustration below shows the sliding credit rating scales of the major bond ratings agencies and a general description of the risk level for each rating.

Graphic of major bond ratings agencies' credit scale

What to buy: 

USD investors: 1-2 year liquid corporate debt of investment grade

EUR investors: 1-2 year liquid corporate debt of investment grade

GBP investors: 1-2 year liquid investment grade corporate debt

DKK investorsSame as above for EUR investors (Note: this means some currency risk for the Danish investor, although the DKK has been essentially pegged to the German Mark and then the EUR since the early 1980’s – and is only allowed to trade in a very narrow band, officially 2.25% but has only fluctuated about 0.3% either side of the average for the last 20 years.)

Note: You can use the Bond screener in your Saxo Platform to choose specific bonds, including those with a smaller minimum trading amount. Note that any bond yielding significantly more than 50-75 basis points (0.50%) above the safest government bond rates is likely edging toward a non-investment grade cut-off.

What to buy if looking for higher yielding bonds?

Investments in high-yield bonds is beyond the scope of this article. Formally speaking, “high yield” corporate debt is debt rated below investment grade by the bond ratings agencies and is only an option for more risk willing investors. In times of an improving economic outlook or times of falling yields and stable to improving credit markets, high yield bonds can offer far better returns than higher rated debt, but are of course more risky in general and the most risky when the economy is heading into a rough patch or recession, when default events can occur and bond holders may only recover a portion of their initial investment. High yield bond prices for longer maturity bonds of five years or more can be extremely volatile, easily fluctuation 10% within a month. Risk-willing investors can consider high yield bond investments, but should do their due diligence on the risks of investing in this space, as well as understanding the credit risk of any single company before purchasing its bonds. The higher the implied yield of the bond, the worse the credit rating and higher the presumed default risk.

–> Finding and trading bonds in Saxo’s Platforms:

If you have the full 12-digit ISIN number for the bond, you can always enter this into the Instrument Search box, the quickest way to get to the right place. Otherwise, if you would like to explore the extensive variety of bonds Saxo offers before making a decision, to the right of the Instrument Search o. For a more thorough guide on how to discover and screen for specific bonds and how to buy them, consult the relevant how to guide below.

If you use the Saxo Investor platform, consult this how-to guide for finding and buying bonds.

If you use the SaxoTraderGO platform, consult this how-to guide for finding and buying bonds.

Appendix of special topics

Bills versus bonds.

The shortest-tern government fixed income securities that mature within a year of issuance are called bills. These are not issued with a coupon, but are instead issued at a discount to par. The interest is paid as a function of the progress toward the price at issuance and the appreciation of the bill’s price as time transpires toward maturity. So, for example, if the 1-year yield is near 4%, a twelve-month US T-bill would be issued just above a price of 96, paying no interest but maturing at 100 on the maturity date 12 months later. If the holder sold the T-bill after six months and interest rates are still near 4%, the seller would realize a price of close to 98, i.e., close to 2% actual appreciation for half a year, or an annualized yield of 4%. 

Special considerations for Euro Zone sovereign debt

The EU, with its monetary union is an awkward construct, given that each EU member government in the monetary union must fund itself from domestic revenue in theory, with the ECB as the single central bank. As individual members have no power over the central bank itself, this has generated concern that peripheral EU countries with weak growth and that are highly indebted, especially Italy and Greece, may one day default on their Euro-denominated bonds. This concern drove a disorderly sell-off in Italian, Greek and other peripheral bonds during the EU sovereign debt crisis of 2010-12. In response, the ECB eventually moved aggressively to purchase enormous quantities of EU sovereign debt and more recently has even tilted its purchases more toward the peripheral debt from Italy and elsewhere to avoid “fragmentation” of its monetary policy. This year, the ECB aims to stop purchasing debt entirely and even sell it, a process know as quantitative tightening or QT that will reduce the size of the ECB’s balance sheet. Still, even while maintaining a policy of QT, the ECB may shift its legacy holdings and still be a net purchaser of the most fragile nations’ debt while its overall balance sheet shrinks. Most other developed market central banks, Japan a prominent exception, started the QT process last year. Still, the foundational problem in the EU of one central bank and multiple sovereigns will mean that there is some residual risk that a country without control of its currency may leave the euro and default on its bonds. That is why, as of this writing the Italy 10-year BTP, Italy’s sovereign bond, trades with a yield of 4.55%, while the German 10-year Bund, trades at 2.7% as of this writing.

Floating rate bonds/notes.

Floating rate bonds are bonds with a variable coupon. The coupon is typically reset every 3, 6 or 12 months at some level, or spread, relative to a benchmark rate. That benchmark rate is often a short term interbank rate for 3 to 12 months like EURIBOR, ESTR, SOFR, CIBOR, etc., or even a central bank policy rate.

These bonds typically trade very close to par, as the coupons mostly reflect the yields in the market as they are often reset. Floating rate bonds are interesting for investors wanting to receive the short term market yields (like now where yield curve is inverted, meaning that short yields are higher than long yields) while trying to avoid the risk of significant capital losses. This is because floating rate bonds usually are less volatile. Floating rate bonds are also of interest for investors that want to benefit from rising short term interest rates.

Why trade floating rate bonds/notes? The primary reason to consider these is avoiding significant capital losses if you aren’t sure you will hold even shorter maturity bond investments to par, but also if you are very concerned that yields are set to continue rising aggressively. Floating rate notes are available from both governments, local governments (many of these with very high credit ratings) and corporations.

Portfolio allocation to bonds according to one widely used model.

There is no one-size-fits-all answer to the question of how much of a portfolio investors should allocate to bonds, as the appropriate allocation will depend on a number of factors, including the investor's goals, risk tolerance, time horizon and current market conditions.

That said, a widely circulated rule of thumb among financial advisors for determining an appropriate allocation to bonds is based on the investor's age. With the assumption that bonds offer lower, but less volatile returns than stocks over time, the rule of thumb suggests that investors should subtract their age from 100, and allocate that percentage of their portfolio to stocks, with the remainder allocated to bonds.

For example, a 30-year-old investor would allocate approximately 70% of their portfolio to stocks (100 minus 30), and 30% to bonds. As the investor gets older and approaches retirement, the allocation to bonds would gradually increase, as a way to reduce overall portfolio risk and volatility.

It's important to note that this rule of thumb is just one approach to determining an appropriate allocation to bonds and may not be suitable for all investors.

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