October 27, 2022
Today’s investors have much greater access to the stock market — they can open a brokerage account on their phone, access to market information and data, and access many asset classes and investment options. This growing abundance of options is great, but investors may want to become more educated about all investment options before making an investment decision. But in spite of the abundance of new options, some of the classics still have a place: the bond market might be one of those famous classics which has gone by the wayside.
Famous investors of our times such as Warren Buffett have explained the benefits of diversification at length; namely, how remaining diversified could shield a portfolio from losses. Warren Buffett even thinks of diversification as “protection against ignorance”. With so many diversification strategies out there, one can easily get lost and not be sure where to invest his money.
So, how can bonds help diversify the portfolio of beginner investors? To answer this question, we will first define what a bond is, how it differs from a traditional stock, and finally explain how bonds can help diversify the portfolio of beginner investors.
What is the bond market?
The bond market refers to a loan given to a company or government in exchange of paid interests. For stocks, the investor purchases shares in the company. By owning these shares, the investor owns a portion of the company.
For bonds, the investor is simply giving a loan to the corporation, with predetermined rates and timelines for when the investor should get paid back. Many investors think of bonds as a safer investment over stocks, as the chances of a speculative-grade bond defaulting have been at 2.1% over the past 12 months, according to Moody’s. Even when a bond does default, it does not mean that the entire principal has been lost; only the remaining bond payments will have defaulted, so the investor is still able to recover some of his initial investment even after the bond has defaulted.
Bonds have two main factors: the price of the bond and the yield of the bond. When a bond price increases, the yield decreases. The opposite is also true: when bond prices decrease, then the bond yield increases. This is because if a company issues new bonds at a higher yield rate, then people will want to sell their current bonds and buy the new bonds. They will be willing to sell their old bonds at a discount, knowing that the new bonds will offer them better interest. Of course, if the yield rates are decreasing, then people who held onto the older bonds can sell their bonds for more than what they purchased them for, as people will want those bonds that deliver a higher yield rate.
Advantages/drawbacks of a bond?
A common advantage of a bond is the relative security that it provides. Of course, no investment tool or class is completely immune to risk, but bonds (especially high-grade bonds) are considered some of the lowest-risk investments that someone can make. In modern history, the US government has never defaulted on its government-issued treasury bonds. Considering the US government has always managed to pay back its bonds, it’s likely that the US treasury might continue to pay back its bond investors in a timely manner. So, the largest advantage of US bonds is the safety and security that it provides to the investor.
On the other hand, corporate bonds, which are bonds issued by companies, have a higher risk of default if the company goes bankrupt and that’s why you’ll often see corporate bonds with a higher interest rate. The higher the interest rate, the higher the risk.
The downside of bonds is that they often are fixed-rate, and usually do not provide yields as high as the stock market. Although the yield rates on bonds have been increasing over the past year, they still cannot provide the same returns that speculative stocks and assets can provide.
For example, I-bonds can deliver close to 10% yields over the next 6 months which is closer to some high-yield stocks, but they also represent a higher risk compared to the bond market. Furthermore, I-bonds are extremely limited in terms of the amount of capital that you can allocate to, with there generally being a limit of $15,000 that can be used to purchase I-bonds per person. Because of this limited cap on the amount of I-bonds that can be purchased, the rate on the I-bonds is generally higher than the rest of the bond market.
Also, considering the high inflation rates, sometimes the bond yields are lower than the rate of inflation! For example, if a 10-year bond gives the investor 1% ROI per year, but the rate of inflation is currently at 3%, our bond investment would not be profitable when factoring in inflation! Of course, inflation is variable, so perhaps the inflation cools down over time and the bond becomes profitable again in the future.
To sum it all up: The bond market offers some advantages compared to stocks, mainly in terms of stability. However, bonds may not offer the same rate of return that a riskier investment in the traditional stock market can yield. That being said, some investors consider bonds due to the stability they offer.
How can bonds markets help diversify the portfolio of beginner investors?
Many beginner investors might likely be drawn to the big flashy names making all of the headlines. Beginner investors likely want to see their investments grow at a rapid pace, and want results. However, a portfolio that relies solely on stocks may experience more volatility than a well-diversified portfolio would. This can lead to unpleasant surprises for the investor, as he watches his investments crumble.
Bonds could help beginner investors achieve some sense of stability for their portfolio: when every other investment is going South, bonds are another asset class that can be used to diversify one’s portfolio and keep it stable.
Of course, bonds are not without risk, and if one needs cash from a bond before it matures then they could lose principal by selling the bond to someone else. This would be the case if someone buys a high-yield bond at a point in time, then wants to sell the bond a few months later when the yields for that bond have increased even more.
There is no perfect metric for how much should be allocated to bonds, as that allocation will ultimately depend on every investor’s strategy and plan. However, bonds diversify the portfolio of beginner investors by having them invest in an asset that could help preserve their wealth. Wealth preservation requires different skill sets compared to wealth appreciation. During these times of uncertainty, it could make sense to preserve a portion of our portfolios in risk-averse assets such as bonds.
So, how much of your portfolio are you considering to allocate to bonds?