Bonds play an important role in all but the highest risk portfolios. They provide a predictable income stream, and typically do well in times of stress. That means they help offset declines in sharemarkets, so a portfolio that has shares and bonds will have fewer ups and downs than one which is all shares or all bonds. This is called a “portfolio diversification benefit”. Our research house MyFiduciary believes these benefits are more certain and more real now than they were a year or so ago. This is because short-term interest rates and bond yields have both risen to more like their longer-term averages. They believe we can expect returns of 5% p.a. or more from most NZ and offshore bond funds, whether they are of short or longer-term duration, given their current yields. Most of the bond funds in our clients’ portfolios comprise highly-rated investment grade (IG) bonds. While issuers of IG bonds very rarely default on their debt obligations, this does not mean that they are risk-free. Bonds can still suffer negative returns even when there is no default, for several reasons:
- The assessed creditworthiness of the issuer deteriorates, causing the value of the bond to decrease. An example would be if the NZ government has a credit rating downgrade.
- Interest rates rise by more than is factored into bond prices when they are bought. This is the main reason why bonds suffered a large decline in 2022, and why we allocated to “short duration” bonds earlier to reduce this risk.
- Some bonds may be difficult to sell during times of market stress. In these circumstances the investor may have to sell them at a lower price.
- Finally, most bonds pay a “coupon” (regular income payment) that is fixed and does not adjust for inflation. That means “real” (after inflation) returns will fall when inflation rises, as it has over the past year
Our clients’ exposure to bonds is in the form of well diversified bond funds that have been selected in part to mitigate the risks above. They’ve also been selected because of the strong conviction we and MyFiduciary have that we have the right fund managers – their track record, ethical investment credentials, business stability, and how they control investment and other risks.
Finally, while bonds are not risk-free, we still prefer them to term deposits for most investors for several reasons:
- Bonds typically offer a higher yield than term deposits. They have the potential for capital gains, unlike term deposits.
- An investor can sell their holdings in most circumstances at any time without financial penalty, unlike term deposits where “break fees” typically apply.
- A diversified portfolio of bonds may in fact be lower risk than putting money “in the bank”. The Global Financial Crisis (GFC) in 2008, and the more recent wobbles in US banks, show us that bank deposits are not risk-free. Furthermore, NZ does not have a deposit guarantee scheme, and the scheme expected to be enacted later this year will only guarantee up to $100,000 per investor.