There is a bond for every desired investment outcome

Bonds have long been thought of as a bit dull — there to generate some income and reduce overall portfolio volatility while equities do the heavy lifting of capital growth. But that is only part of the story.

There is a bond to suit every outcome an investor would want from a broad-based portfolio: price appreciation, capital preservation, income, inflation protection, diversification, targeted exposure. Whether an investor wants the most conservative portfolio or the most aggressive one, it could be constructed entirely with bonds.

For every risk appetite

The safest are sovereign, or government, bonds. And at the top are US Treasuries, which are often considered to be close to being risk-free. Next are investment-grade corporate bonds, moving down through the credit ratings until they cross over into high-yield or “below investment grade” bonds. For the really brave, there is distressed debt, which focuses on financially troubled companies needing restructuring.

Whatever the type of bond, there is a distinction between safer developed markets from the biggest economies and more volatile emerging markets.

Most bonds have fixed rates of return, although many offer coupons that fluctuate with interest rates or inflation or some other metric.

Naturally, the safer a bond, the less it pays in terms of yield. Duration is another factor, with longer-maturity bonds usually offering a higher yield to compensate for a longer wait before your capital is returned.

The bond market is “a very large and diverse opportunity,” says Kirstie Spence, fixed income portfolio manager at Capital Group. “You can create a multi-sector fixed-income portfolio, which has that capital preservation from the high quality, but at the same time you have a high-return potential from the higher-yielding emerging markets.”

In a recent survey of high-net-worth investors by Capital Group, the ones that plan to invest more in bonds in the next 12 months (49 per cent) have a bias towards quality; 89 per cent favour government bonds, 85 percent favour high yield bonds and 84 per cent veer towards investment grade corporate bonds.

“Bonds offer an appealing combination of income, return and diversification,” says Mark Haefele, chief investment officer at UBS. “Quality bonds offer attractive yields and should deliver capital appreciation if interest-rate expectations decline as we expect.”

A safe haven

Like equities, bonds will behave differently according to the economic cycle. The worse the economy is doing, the better the safest bonds are likely to perform, because interest rates are likely to fall. High-yield bonds, however, are more likely to fall in value because of concerns over default due to the issuer struggling to sustain profits. Conversely, if economies are growing there is less risk in holding lower-grade credits, because the issuer is likely to perform better financially. Even if a boom prompts central banks to raise rates, corporate bonds can still perform adequately.

“Over the last seven Federal Reserve hiking cycles, core bonds have doubled the returns of cash on average over the two years following the final rate increase,” says Grace Peters, global head of investment strategy at J.P. Morgan Private Bank. “And fixed income has never underperformed cash during that period.”

For now many institutional investors are sticking with high quality bonds. “We are in high grade bonds at the moment because we think the pick-up in high yields (from below investment grade bonds) when compared with investment grade yields is not attractive enough, even if you only see a very small increase in default rates,” says Willem Sels, global chief investment officer at HSBC Global Private Banking and Wealth.

High-yield bonds behave most like equities, but the “high yield = high risk” cliché is often misinterpreted. While the risk of a corporate bond default is considerably higher than for a government bond, the actual risk is low. And if a company goes bust, it will be the shareholders that bear the losses first - ahead of the bond holders.

Take a bond with a BB rating, which is just below investment grade: the average annual default rate over the 40 years to 2022 was just 0.66 per cent, and the highest ever was only 3.06 per cent (in 1990). And a default does not rule out some capital being returned.

“It doesn't mean you lose your capital — it means you just have more volatile price action,” says Capital Group’s Spence. Even so, “high-yield corporate bonds have the potential to provide long-term returns that are similar to equities, with much less volatility and much less risk. It’s a way to diversify from your equity exposure.”

Overall, there is a bond to match every risk appetite and they are also perfectly suitable for driving capital returns - not just income. “We believe that there is value in building diversified broad based portfolios and diversified yield portfolios for several reasons,” says Kristen Bitterly, head of investment solutions Citi Global Wealth. She explains that this is because Citi sees the Fed funds rate being cut over the summer months, that inflation is falling and there is still substantial cash on the sidelines. These are factors that offer compelling reasons to remain invested and diversified.