Should You Invest In Bonds?

In the landscape of investment strategies, one tried-and-true asset class is making a notable comeback—bonds. During the low-interest rate climate of the past 15 years, investors may have questioned the role of bonds in a portfolio. However, with interest rates currently back to rates not seen since 2009, many are again seeing the benefits of including bonds in a portfolio.

In this blog, we'll explore what type of investment bonds are, how they fit into to your portfolio and draw insights from the recent resurgence of interest in this asset.

Bonds are a type of fixed-interest investment where you essentially lend money to a company or government. As a bondholder, you become a lender, and in return, you receive periodic interest payments known as "coupons."

Bonds are different to term deposits in that you can sell a bond without waiting for the term to end. However, the price you get by selling bonds changes according to market conditions.

If you hold your bonds until maturity, and assuming the lender (company or government) doesn’t fail, you get the face value of your investment back. Along the way, normally twice annually, you receive a coupon of half the interest rate promised.

The interest rate, also known as nominal yield, at the time of issuance and the current yield as at today, depends on several factors such as:

• Central bank interest rates,

• Inflation expectations

• Time to maturity

Equally, another factor is the likelihood that a borrower will be able to make their required repayments to a lender, this is known as ‘credit risk’. 

Credit risk is often assessed by credit agencies, who apply a “credit rating” to bonds they assess. Below is a condensed list of a typical credit scale.

Bond yields are higher when the risk of default is perceived to be greater. Conversely, the bond yields are lower when the risk of default is perceived as lower.

“Investment-grade” is a term meaning bonds with a minimum credit rating of BBB.

These bonds are perceived to have a relatively low risk of not paying back their obligations. The credit rating reflects the relative risk, with A, AA and AAA being respectively higher credit qualities.

For everyday investors, accessing bonds directly requires significant capital, often $10,000 each, making bond funds a less attractive option to create a diversified portfolio. Additionally, the coupon is taxed at the investor's income tax rate, of up to 39%.

Bond funds provide exposure to a range of bonds, offering diversification compared to lending all your money to a single issuer, at a low cost, with PIE tax benefits and often with no minimum investment.

Learn more about Kernel’s range of bond funds here.

Rather than asking “Is now a good time to invest in bonds?” we’d suggest to ask, “Are bonds suited for my money goals?”

Generally speaking, bonds in an investment portfolio have been viewed not as return enhancers but rather as volatility dampeners.

The reality is, if you’re investing in shares through well-diversified index funds for a long-term goal (10+ years) you shouldn’t be overly concerned about the change in short term valuations. This is because you’ve got time to wait for your funds to recover and should expect (but not guaranteed) a higher return on your investment.

However, if you expect that you will need your investments sooner (maybe 3-5 years from now), for example with a fixed goal, such as to use for retirement or your purchase of your first home, then it’s generally considered wise to have some exposure to bonds.

As the meme-stocks and market turbulence of 2020-23 have seemingly quietened down, a group of investors known as "Bogleheads" are championing a philosophy that's proved resilient—lazy investing.

The term derived from Jack Bogle, founder of the index fund, which advocates for low-cost, passive investments that compound over time.

With the recent surge in interest rates and the decline of meme stocks, Bogleheads are finding their approach particularly well-suited to the current market conditions – even garnering attention from media.

One of the cornerstones of the Boglehead philosophy is the inclusion of bonds in a diversified “balanced” portfolio. Traditionally known for their stability, bonds are experiencing a renewed appeal among investors seeking a counterbalance to the volatility seen in shares.

Balanced is a term meaning having both growth investment like shares and income investments like bonds in roughly equal proportions.

Many investors like to include bonds in their portfolios due to their characteristics, especially during periods of economic uncertainty and attractive interest rates. Here are a few favourable characteristics of including bonds in your portfolio:

Historically, bonds tend to show resilience during economic downturns.

When central banks use interest rate reductions to stimulate economic growth in a recession, bond values tend to rise. This can make bonds an effective counterbalance to shares during times of share market stress from perceived lower earnings and potential.

A notable example of this can be seen in 2008-2009 during the Global Financial Crisis where we saw an increase in the bond markets, while the equity markets decreased.

Below shows the performance of the Bloomberg US Aggregate Bond Index and the S&P 500 Index during that period.

One of the key benefits of investing in bonds is the regular income they provide through interest payments known as coupons.

As mentioned, when you buy a bond, you essentially become a lender and in return, you get paid with interest. This predictable income stream can be attractive for investors looking for a stable source of cash flow.

The contractual nature of bonds provides a high degree of certainty and stability because of its underlying investments.

In the context of a company undergoing bankruptcy, the order of payment priority usually favours those who have provided loans to the company such as bondholders, over those providing equity, the shareholders.

Bonds can also be linked with collateral in the form of physical assets like buildings or machinery, providing an added layer of security. These factors significantly increase the likelihood of receiving payment.

Note: characteristics may vary depending on the types of bonds and credit rating.

While bonds have many benefits, it’s essential to know bonds don’t always provide protection or diversification and still incur risks such as:

Unlike shares, bonds have limited growth potential. While they can provide stability, they often don’t offer the same wealth-building opportunities over the long term as shares.

However, it is important to note that bonds and shares are ultimately different asset classes and have their unique risks and benefits. Choosing which asset class for you will depend on your risk profile and time horizon.

When interest rates rise, the value of an existing bond falls. This reverse relationship can lead to capital losses for bondholders, especially in an environment of increasing interest rates.

A recent example of this was between 2020-2022. Bond investors began to expect the Reserve Bank of New Zealand (RBNZ) to increase the Official Cash Rate (OCR), which later changed from nearly 0% to 5.5%.

The increased rates caused many funds holding bonds, including “conservative” funds to experience negative returns.

A tool often used to help manage this risk is called duration.

Duration measures a bond's sensitivity to interest rate changes; a higher duration suggests greater susceptibility to interest rate risk.

This is the risk that the issuer may not meet its payment obligations. Credit ratings, as mentioned earlier, help investors assess this risk. Higher-rated bonds have a perceived lower default risk and vice versa.

While bonds can offer predictable income, the impact of inflation can erode its real returns over time. In periods of high inflation, the purchasing power of fixed-interest payments may decline.

For example, if inflation is 5% and the yield of a bond is 6%, with a personal income tax rate of 33%, then the after-tax return is 4.02%.

However, after it is adjusted for inflation, your real return is almost -1%.

Are bonds a good investment? Once again, the answer to the question is, it depends on who’s asking.

Deciding whether to invest in bonds, should come down to your financial goals, risk tolerance and timelines. Following the shift in higher yields, bonds are more attractive for many investors.

Recognizing this trend, many investors are exploring fixed-interest options to capture higher yields and diversify against uncertain economic conditions.

If you value stability, regular income, and capital preservation, bonds can play a crucial role in your portfolio.

However, it's equally important to diversify across different asset classes and be aware of potential risks, such as interest rate fluctuations, limited long-term growth potential and inflation erosion.

A well-diversified investment approach often involves a mix of assets tailored to your financial circumstances and goals.