The role of bonds in a portfolio

21 January 2022

At a time when fixed income yields are extremely low, it is important for investors to understand how their bond holdings are measuring up, says Chris Miles, Head of UK Intermediaries at Capital Group.

Different fixed income asset classes are designed to meet different investment needs. Building a resilient and balanced portfolio is important in today’s environment of heightened financial market uncertainty and volatility across a range of asset classes.

Primarily, fixed income serves four key roles in a portfolio: capital preservation, income generation, inflation protection and diversification away from equities. It is important for investors to understand how their bond holdings measure up against the full benefits of investing in bonds, particularly at a time when fixed income yields are extremely low.

With that in mind, now is an opportune time to address the role bonds can play in a portfolio:

Capital preservation: An allocation to bonds can be the anchor for a durable and resilient portfolio as it can provide stability in times of uncertainty. Bonds issued or guaranteed by stable governments or corporations with good business models and solid balance sheets, can be key building blocks for a capital preservation strategy. Even in the low yield environment that we have been experiencing for years now, fixed income has fulfilled its role of preserving capital.

Although losses can occur over short-term time horizons, history shows that high-quality fixed income investments can offer a measure of stability over time. Short-term periods of losses have tended to be minor in comparison with declines in equities, and the good news is that the historical default rate is low for high quality bonds and is virtually zero for developed countries’ government bonds.

Income: It’s called fixed income for a reason. Unlike equities, bonds carry more explicit and predictable income streams in the form of coupon payments to investors, so long as the issuer remains solvent. While the yield will fluctuate with the price, coupons on fixed rate bonds typically do not change. For this reason, bond funds provide some income, with higher yielding bonds generally associated with additional risk. This steady source of investment income can play an important role for many investors, such as retirees who may rely on it for monthly living expenses.

While income should be a component of any diversified portfolio, it is prudent to monitor the portion of a fixed income allocation dedicated to higher yielding bonds. Specifically, these holdings should not be regarded as a key source of capital preservation or diversification from equities — they may not perform those roles well

Inflation protection: In a modestly higher inflation environment supported by stronger growth, safer bonds that are more interest-rate sensitive such as UK Gilts tend to suffer. However, other segments of the fixed income market such as inflation linked bonds, investment grade and high yield tend to perform well alongside a better economic environment. We saw this last year with inflation in many parts of the world increasing rapidly and significantly, high yield and inflation linked bonds both posted positive total and excess returns year-to-date.

Diversification away from equities: Correlation between asset classes has increased recently in an environment of extraordinary accommodative monetary policy, but when equity markets recently experienced volatility and corrections, higher quality bonds still provided resilience and diversification. Some bond allocations may not be ideally positioned to weather a stock market decline, holding potential ‘hidden’ risks in the form of high correlations to the equity portions of a portfolio. For instance, they may have an outsized allocation to higher yielding bonds, which historically have had a high correlation to equities and tend to decline in value when stock markets decline. In contrast, government bonds such as UK Gilts or US Treasuries have tended to provide good diversification from equities.

Market opportunities

With soaring valuations, finding opportunities for value in today’s bond markets isn’t easy. Persistently low yields have driven some investors to take on greater risk in search of income. Yet when looking for income across bond sectors, not all options are equally attractive, and a research-driven approach can help differentiate among sectors and securities.

For an investor concerned with rising interest rates, high yield could appear a better choice. Its duration — a measure of sensitivity to interest rate risk — is lower than that of government bonds or investment-grade corporates. The latter have seen their duration profile rise in recent years. US high-yield corporate bonds have also improved in credit quality, with their highest quality BB- rated bond portion growing recently. This means that even with credit spreads approaching historically tight levels, there may be some upside for select bonds within the sector. Of course, high yield also contains more credit risk, so it might not be appropriate for investors looking for diversification from equities.

There are also diversification benefits and attractive income opportunities from combining high yield and emerging market bonds, which is what our Capital Group Global High-Income Opportunities (GHIO) fund does. GHIO combines asset classes with similar risk-return profiles but following different market cycles to diversify the risks associated with high-yield investing with the potential for more consistent income and less volatile returns. For example, in a year such as 2021 which was challenging for fixed income and emerging markets bonds in particular, high yield posted strong positive returns with positive impact on GHIO results.

Considering all the varying attributes of income sectors and their specific bonds is necessary to achieve success in this environment and flexibility to move from sector to sector when new opportunities arise is key. Balance is key for long-term investing and investors who seek a balanced portfolio should ensure that their fixed income allocation serves all four key roles outlined above. These roles can aid in pursuing retirement goals or simply help stabilise a portfolio to be more resilient when economic shocks hit markets.

Professional Paraplanner