Balancing risk and return with bonds
05 May 2017 | Asset classes
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.
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.
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