In the ever-evolving landscape of world affairs, certain investment assets have stood the test of time, proving their worth in diverse portfolios.
Bonds, often overlooked, deserve a renewed appreciation, especially in the context of recent economic shifts.
In a recent Annual Review, a client enquired, “Should we still be invested in bonds?”
This article aims to demystify bonds, highlight their historical significance, discuss their recent performance, and look forward to why they remain a vital component for investors with a lifelong investment horizon.
What is a Bond?
One of the first issues with bonds is confusion over the use of the term.
It’s common for the term “bonds” to be used in three different ways. The first, is a type of insurance product sold often by banks, known as an “Investment Bond”.
These are part investment, part insurance product and often, the underlying investment inside an Investment Bond are equities.
In this context, I’m not talking about that type of bond.
The second is a fixed rate bond, sold often by instiutitions like NS&I that will pay the holder an interest rate for a period of time.
Often, the capital is protected, as is the rate of return.
We’re getting closer but still not the correct context for this blog.
The third type of bond makes up the enormous and global bond capital market.
It is these bonds to which I refer in this article.
These are the bonds that we use in your Navigate portfolio and they play a very significant role in finance.
The bond market is six times that of the equity market and yet, it receives only the fraction of the media coverage.
Simply put, a bond is a loan made by an investor to a borrower, typically a corporation or government.
The borrower agrees to pay back the loan amount (the principal) on a set date (maturity) and, in the meantime, pays the investor interest.
This interest is usually paid at fixed intervals, making bonds a predictable source of income.
Think of it as a formal IOU where you, the investor, play the role of the bank.
The Historical Importance of Bonds
Historically, bonds have been a cornerstone of well-diversified portfolios.
They provide stability and income, often acting as a counterbalance to the more volatile stock market.
For example, during the 2008 financial crisis, while stock markets plummeted, government bonds, especially U.S. Treasuries, gained in value.
Investors seeking safety flocked to bonds, demonstrating their role as a 'safe haven' during market turmoil.
In periods of low-interest rates, corporate bonds have offered better returns than government bonds, attracting investors seeking higher income.
The 2022 Scenario
The year 2022 was challenging for bonds.
Rising inflation, coupled with aggressive interest rate hikes by central banks, particularly the Federal Reserve, led to a decrease in bond prices.
We have had surges in inflation before, most notably the late 1970s but never before have we seen such aggressive increases in interest rates at the same time.
The Bloomberg U.S. Aggregate Bond Index (a good index for world bond prices) was down -12.5% from its highs, which was more than double any previous peak-to-trough decline since the 1970s.
The difference this time is that Central Banks acted faster and in more aggressive fashion than the 1970s, where they let inflation run first, hoping other market forces (mainly oil prices) would come down.
In short, short term pain we all experienced in 2022 may have saved the day and stablised the markets for future years.
The Future of Bonds
Despite the recent downturn, the future looks promising for bonds.
As inflation stabilizes and interest rate hikes slow down, bond prices are likely to recover.
Furthermore, bonds still continue to offer diversification benefits.
In a volatile market, they can provide a buffer against stock market fluctuations.
In the last few weeks – led by global events, such as the Israel–Gaza War – bonds have been one of the best-performing assets.
Additionally, as economies recover and stabilise, corporate bonds now offer attractive yields, and this is likely to drive demand for bonds, especially new issues, over the next few years.
Conclusion
Bonds – like any long-term relationship – may have their ups and downs, but their fundamental qualities of stability, income generation, and diversification make them an essential part of a diversified investment portfolio.
As we navigate the complexities of the global economy, bonds remain a reliable partner for investors aiming for long-term financial success.
It's time to revisit and strengthen our bond with bonds, as they can play a pivotal role in our investment journey.
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