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Balancing risk and return with bonds

05 May 2017 | Asset classes

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As yields rise, bond investors worry about capital losses. But Ankul Daga, investment strategist with Vanguard Europe, reminds investors of the two critical functions bonds have in a portfolio – risk reduction and stable returns.

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Ankul Daga: Pound sinks. Inflation at two-year high. Warning on bond bubble. With these headlines, it's no wonder that many investors are asking "Why invest in bonds?"

I'm Ankul Daga, investment strategist at Vanguard. I can help you answer your clients' questions about bonds in the current environment.

Investors need to remember the two reasons they invested in bonds in the first place: stable returns and risk reduction. These two features are why bonds play a vital role in a balanced portfolio no matter what the worries are about rates, yields or inflation.

We know that as yields rise, the price of bonds will fall. This could lead to a capital loss. But this ignores the fact that bonds are still paying an income stream, and that income is re-invested at the higher yielding rate. This compounds over time and improves total returns. So even when rates are rising at a gradual pace, the downside from holding bonds is limited.

The second function of bonds in a portfolio is their ability to reduce overall volatility – or their diversification benefit. This is because of their low correlation with equity returns.  

Even when bond returns are low, their risk reduction benefit contributes to a portfolio's long-term success. We've analysed a balanced portfolio of 50% global equities and 50% high-quality global bonds. Looking at the chart, the (green) bars show the reduction in risk from holding bonds over the last 30 years in distinct three-year periods. We can see that when the diversification benefits was at its strongest, bonds still produced modest total returns – shown by the blue bars here. Similarly, when bond returns were higher, holding bonds in a portfolio still helped reduce risk.

So over these distinct three-year periods, bonds have consistently delivered stable returns and diversification benefits. This holds over most time periods. During shorter time frames investors might experience more noise, or in other words idiosyncratic risk. But over the longer term, this trend persists.

There is always uncertainty in the market, whether it's about the next change in interest rate, the potential for inflation or the possibility of yields rising. The best way to handle this is to encourage your clients to stick with their long-term strategic asset allocation of a broadly diversified and balanced portfolio.

Thank you for watching.

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Important information:

This video is directed at professional investors and should not be distributed to, or relied upon by, retail investors.

This video is designed only for use by, and is directed only at persons resident in, the UK. It is for educational purposes only.

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested. Past performance is not a reliable indicator of future results.

The material contained in this video is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

The information on this video does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this presentation when making any investment decisions.

The opinions expressed in this video are those of individual speakers and may not be representative of Vanguard Asset Management, Limited.

Issued by Vanguard Asset Management, Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.

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