A resilient portfolio is built on bonds

Traditionally, the ideal investment portfolio was split, with a typical 60 per cent in equities for capital appreciation and 40 per cent in bonds for capital preservation and to mitigate the higher risk and volatility of shares. Bonds also provided income, until the global financial crisis (GFC) sent interest rates crashing to zero for a decade, taking bond yields with them.

Falling out of love with bonds?

Bonds should be considered for every portfolio on the basis of their versatility alone. From the safest government bonds to the riskiest corporate debt; from the biggest developed economies to the smallest emerging markets; from triple-A credit to high-yield “below investment grade” debt; in the safety of US dollars, or almost any freely traded currency; fixed-coupon, floating rate or inflation-linked.

“If you look at a portfolio of stocks, bonds and alternatives and you look at a three-year period or even more so over five years, the probabilities of beating cash become better and better. And in a five-year period it's very rare to lose money when you look beyond the horizon,” says Willem Sels, global chief investment officer at HSBC Global Private Banking and Wealth.

But a Capital Group survey shows that 24 per cent of high-net-worth investors hold no bonds at all.

“Given the yields of T-bills and money-market funds, there is certainly a place in the portfolio for them,” says Kristen Bitterly, head of investment solutions Citi Global Wealth. “But there is also a very strong argument for building a diversified fixed-income portfolio locking in some of the highest yields we have seen in more than 15 years.”

Nearly half of the investors in the Capital Group survey see bonds to be as risky as equities. This is a hangover from the GFC, when the inverse correlation between bonds and equities decoupled and they became more synchronised. But between 1989 and 2021 quarterly bond volatility peaked at 6.6 per cent, which is barely higher than equities’ lowest reading of 5.2 per cent and less than a fifth of their peak of 41.4 per cent.

When correlation returned, it was because of the first serious tightening cycle in 15 years, which prompted a bond market sell-off. That rate cycle may reverse now that inflation is lower and the Federal Reserve is signalling cuts this year. This would be positive for bonds.

The three functions of bonds

“Bonds have a clear function in the overall portfolio — income, for sure, but there is also the diversification from equities,” says Kirstie Spence, fixed income portfolio manager at Capital Group. “If you see a normalisation of inflation in that 2–3 per cent range, you should expect the renormalisation of the negative correlation between equity and bonds.”

Bonds’ third key function is capital preservation — the return of capital. Cash merits the same status, and also provides income, but it lacks the potential for capital appreciation alongside preservation. Bonds provide some downside protection to come through difficult periods and reduce the volatility that often prompts poor investment decisions, such as trying to time the markets.

“In 2023, while cash offered safety and you got a return just north of 5 per cent, you would have got 5.5 per cent from investment-grade and 13 per cent from high-yield bonds,” says Grace Peters, global head of investment strategy at J.P. Morgan Private Bank. ''We have been advocating to clients to add fixed income to lock in attractive yields.”

Nearly every investor in the Capital Group survey (99 per cent) holds less than the traditional 40 per cent weighting of bonds, so there is room to increase allocations. About 49 per cent admit that they are bullish on bonds, with 15 per cent looking to add “significantly,” despite some seeing bonds as being as risky as cash. But the combination of the S&P 500 reaching record highs and the Fed signalling lower rates means that the risk-reward may be shifting towards bonds and equities and away from cash.

“Over the next 12 months we prefer bonds, given attractive yields and the likelihood that quality bonds will rally as growth slows and rates fall,” says Mark Haefele, chief investment officer at UBS. “From a portfolio perspective, we also like the fact that bonds would likely perform very well — better than cash — in the event of a sharper-than-expected economic slowdown.”

That attraction may not be enough to get portfolio bond holdings back to the 40 per cent level, partly because of the emergence of asset classes such as alternatives that offer similar benefits of diversification and downside protection. But having a zero allocation risks an unbalanced and volatile portfolio. Bonds have the flexibility to offer a wider variety of benefits than almost every other asset class, which makes them a crucial building block of any investment portfolio.

“You want to increase that fixed-income part of the portfolio because one, you receive the coupon and today the coupon is much more attractive, and two, you're going to get your capital back,” says Capital Group’s Spence. “Today’s yield might provide a similar return to equity, with much lower volatility.”