Understanding bond risk

There is no doubt that bonds play an important role in any diversified portfolio. In fact, for many investors bonds were the only shining light during the dark days of the GFC.

But at the same time, investors need to have realistic expectations about bond returns and understand the risks. It is important that investors understand that bonds are not cash and some categories of bonds and bond funds are riskier than others.

In a recent interview, Vanguard Group chief investment officer in the US, Gus Sauter, said investors should be prepared for more modest bond returns in the future.

While the Reserve Bank of Australia has assumed a tightening interest rate bias, interest rates in the US are hovering at record lows. “At some point, the economy will strengthen and those interest rates will rebound. Investors who have pushed out further on the yield curve by investing in longer term bonds will then see a greater decline in the principal value of their investments,” said Sauter.  

Sauter reminds investors that when you move into longer term bonds you are exposed to greater fluctuations in principal. “Those fluctuations are likely to be negative at some point in the future, and they’ll be negative by a greater magnitude for longer term bonds than for shorter term bonds.”

This doesn’t mean investors should avoid bonds altogether, as they provide significant diversification benefits.  

Bond returns comprise two components: namely yield and capital appreciation or depreciation when the yield changes. When yields decline, as they have been over the last 30 years, bond returns have typically been enhanced by principal appreciation.

“The problem is that when you’re at historically low rates, as we are now, you’re not likely to get more principal appreciation,” says Sauter.

Sauter says that while it is possible that investors could receive a year or more of negative total returns from bonds if interest rates move up sharply, it is not that probable.

Sauter advised that the silver lining to this scenario is that investors will be earning a higher yield. “You’ll have some reduced principal, but you’ll be earning that lost principal back through a higher yield.”

Sauter reminds investors that each asset class plays a specific role in their portfolio, which doesn’t change over time. So, while bonds might deliver double-digit returns one year, they should not be viewed as an alternative asset class to shares.

“Generally speaking, stocks are there for higher expected returns; bonds are there to moderate the volatility associated with those higher expected returns; and some investments, such as money markets, are there to provide liquidity,” said Sauter.

“Even though interest rates are low and return expectations are modest, investors should think about bonds the way they always have,” said Sauter. This means looking at your long term plans and building your asset allocation around that. “That includes a broadly diversified portfolio of stocks, bonds, cash and perhaps, some other complementary investments.”

It is also important to hold diversification within each asset class. Earlier research from the Vanguard Research Group reinforces the benefits of holding a broadly diversified fixed interest portfolio “regardless of the future direction of interest rates.”

The above article has been sourced from Vanguard Investments Australia Ltd.

Important Information

The above information provides an overview or summary only and it shouldn’t be considered a comprehensive statement on any matter or relied upon as such. The above information doesn’t take into account your personal objectives, financial situation or needs. It’s important for you to consider these matters before making any financial decision and I recommend you seek help from a financial adviser.