Fixed income investments can help portfolios absorb market shocks.
People invest their money for all sorts of reasons. Typically among them is the desire to preserve capital, avoid instability and, hopefully, generate some income. In normal times, these are achievable outcomes. But then along came 2020, which has proven to be particularly challenging for everyone, including investors.
As soon as the markets reacted to the financial effects of the COVID-19 pandemic, many investors were tempted to put their money into cash and wait out the situation on the sidelines. However, many experts agree that it’s more beneficial to stay invested, even during tough times. Thankfully, opportunities and strategies exist to help investors do so. One such strategy is to add fixed income investments, more specifically bonds, to their portfolio.
Knowing the basics about bonds can help you understand how they can be an integral component of any portfolio.
How bonds work
Buying a bond is much like loaning money to the issuer, which could be a government or a corporation. In return for the loan, the issuer pays the investor interest at a set rate until the bond matures. The amount of interest depends on the issuer’s financial strength, the time until the bond’s maturity date and interest rates.
In short, a bond is a type of investment that will pay the owner a fixed amount of money over a specific period of time. All bonds have fixed payment and maturity dates, but different types of bonds have different income potentials and levels of risk.
Investors are attracted to bonds for their perceived middle-of-the-road safety and stability. The lower risk profile of bonds usually comes with the expectation of lower returns than from risker investments. However, during times of market volatility, the stability of bonds is often enough to satisfy investors, especially when compared to the more unpredictable outlook for stocks.
Three reasons you might want to add bonds to your portfolio
- Bonds add another level of diversity to your investments that can help absorb market volatility and reduce overall risk.
- There is a wide variety of bonds available, to align with your investment goals.
- Mutual funds and exchange-traded funds are convenient and affordable ways to invest in bonds.
What affects bond performance?
- Market conditions. For example, when the stock market is rising (a bull market), investors typically move away from bonds and into stocks – often referred to as equities. In contrast, when the stock market is going through a correction or downturn (a bear market), investors may seek the perceived safety of bonds, and their prices rise.
- Interest rates. When interest rates rise, bond prices typically fall – and accordingly, when interest rates fall, bond prices increase.
- Credit quality and ratings. A bond’s credit rating is a lot like a person’s credit rating, which can rise and fall due to several factors. A credit rating provides information about an issuer’s ability to make interest payments and repay the principal on a bond. The higher the credit rating, the greater the likelihood that the issuer will meet its payment obligations – at least in the opinion of the rating agency. If the issuer’s credit rating goes up, so too will the price of its bonds. If the rating is downgraded, it will send their bond prices lower. Credit ratings are issued by agencies, such as Moody’s and Standard & Poor’s, that use letter grades (for example, S&P’s AAA to BBB–) to indicate the credit quality of bond issuers and specific bonds.
- Duration. Duration measures how much a bond’s price will be affected by interest rates over the period before the maturity date. The longer the term to maturity, the more sensitive it is to interest rates, which can also present higher income potential. Bond duration falls into three general time frames: short term (1 to 3.5 years), intermediate term (3.5 to 6 years) and long term (longer than 6 years).
When equity stocks depreciated in the early months of 2020, bonds stood up to the test and gained value. Balanced portfolios containing a nearly equal amount of stocks and fixed income investments performed relatively well. The lesson learned is an oldie but a goodie: stay invested, monitor your asset allocation, and rebalance (and repeat) when necessary. Speak to an advisor about how you can make the most out of market volatility.
A bull market is one in which stock prices are rising or appreciating – moving forward like a charging bull. Typically, the economy is strong and employment levels are high.
A bear market is one in which stock prices are declining, like a lumbering or hibernating bear. A bear market is labelled as such if stock values have fallen 20 per cent or more from recent highs and stock prices continuously drop. Typically, the economy slows down and unemployment begins to rise.
What happens in bull and bear markets?
Supply and demand of equities
More investors want to buy stocks, while fewer are willing to sell. As a result, stock prices rise as investors compete to obtain available equity.
More investors want to sell than buy. The demand is significantly lower than supply, and stock prices drop.
Investors willingly participate in the hope of obtaining a profit.
Market sentiment is negative. Declining stock prices shake investor confidence, which causes some to move their money out of the market by reallocating from equities into fixed income securities, such as bonds. Increased outflows in turn put further downward pressure on stock prices.
People have more money to spend and are willing to spend it, which helps strengthen the economy.
A bear market is often associated with a weaker economy, because most businesses are unable to make big profits when consumers are spending less. Lower profits reduce the price investors are willing to pay for a company’s stock.
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