Maintain an even keel

Bonds are an essential part of diversifying any long-term investment portfolio.

By InvestSMART · 13 Jun 2012

By InvestSMART ·
13 Jun 2012

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Bonds are an essential part of diversifying any long-term investment portfolio.

Six months can be a long time in finance. It wasn't so long ago that the smart money was declaring 2012 the year of equities. Bonds, they said, had had a good run. But there was no way they could go any further. The bull market was about to return.

Perhaps not so smart, after all.

During the past two months, bonds have returned a staggering 7.9 per cent while the sharemarket has lost more than 5 per cent.

But, more importantly, bonds are proving a handy buffer against sharemarket volatility, cushioning market falls in a diversified portfolio.

"It's all a bit weird right now," the director of ETF business in Australia for Russell Investments, Amanda Skelly, says. "You'd never recommend anyone put all their money into bonds to chase those sorts of returns, but it shows you need bonds to smooth out volatile sharemarket returns.

"Cash doesn't provide that negative correlation because there is no capital movement."

As the graph shows, bonds have been a great diversifier from shares since the global financial crisis.

When shares have been falling, bonds have done well. And while the opposite is also true, the losses suffered by bonds have been smaller and shorter in duration than those suffered by equities.

In 2011, according to Russell, bonds returned 11.4 per cent shares lost 11 per cent. In 2009, when it appeared the GFC was behind us, shares rose by 37.6 per cent while bonds rose just 1.7 per cent. In the quarter when the GFC hit, the three months to December 2008, government bonds returned more than 11 per cent, while shares lost more than 26 per cent.

Skelly says there have been times, such as in 1994, when market conditions are such that both shares and bonds can fall. But this is uncommon.

She says investors also need to be aware that different types of bonds perform differently. As the graph illustrates, longer-term bonds tend to be more volatile, so more risk-averse investors would be better considering bonds with shorter maturities. "If investors don't want any loss, they'd need to look at the shorter end of the market," she says.

"There are high-quality corporate bonds and even state government bonds [available] and they also offer a bit more opportunity for a higher yield than government bonds. Investors tend to want yield as well as protection."

While bonds may now be reaching the top of their cycle, Skelly says there is so much uncertainty about that it is impossible to make a prediction on where they'll go next. She says the message is more about their diversification benefits than whether there is still scope for big returns.

While retail investors can find it difficult to build a diversified bond portfolio due to the larger minimum investment generally required, companies such as iShares and Russell now offer exchange-traded bond funds that provide an alternative to traditional managed funds. A report by ETF Consulting this week found that while fixed-interest ETFs had experienced a slow start since their launch earlier this year, they are likely to gain popularity.

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Frequently Asked Questions about this Article…

Why should everyday investors include bonds in their investment portfolio for diversification?

Bonds act as a buffer against sharemarket volatility by often moving differently to shares. The article notes that when shares fall, bonds have frequently done well (for example, bonds returned 7.9% while the sharemarket lost more than 5% over a recent two‑month period). Amanda Skelly of Russell Investments says bonds help smooth out volatile sharemarket returns in a diversified portfolio—something cash can’t do because it has no capital movement.

How have bonds performed recently compared with shares?

According to the article, bonds returned a staggering 7.9% over a recent two‑month period while the sharemarket lost more than 5% in the same time. The article also cites historical examples: in 2011 bonds returned 11.4% while shares lost 11%; in 2009 shares rose 37.6% while bonds rose 1.7%; and in the three months to December 2008 government bonds returned more than 11% while shares lost more than 26%.

Do different types of bonds perform differently, and which are less risky?

Yes—different bond types and maturities perform differently. The article explains that longer‑term bonds tend to be more volatile, so more risk‑averse investors often prefer shorter‑maturity bonds to reduce potential losses. It also notes that high‑quality corporate bonds and state government bonds can offer a bit more yield than (federal) government bonds, giving investors a trade‑off between yield and risk.

Should I move all my money into bonds to chase recent high bond returns?

No. Amanda Skelly from Russell Investments advises against putting all your money into bonds just to chase returns. While bonds may currently have strong returns, there is uncertainty about where they’ll go next. The key message in the article is that bonds are valuable for their diversification benefits rather than as a place to chase outsized returns.

What role does bond maturity play in managing risk in a bond portfolio?

Bond maturity affects volatility and potential losses. The article points out that longer‑term bonds are typically more volatile and can experience larger price swings, whereas shorter‑dated bonds are generally steadier. For investors who want to minimise the chance of capital loss, the shorter end of the bond market is recommended.

How can retail investors get diversified exposure to bonds without large minimum investments?

Retail investors often face large minimums when building a direct bond portfolio, but the article highlights exchange‑traded bond funds as an alternative. Companies such as iShares and Russell now offer bond ETFs that make diversified fixed‑income exposure more accessible to individual investors.

Are fixed‑interest ETFs a good alternative to traditional managed bond funds?

The article suggests they are a viable alternative. Fixed‑interest ETFs provide easier access and diversification for retail investors who may find direct bond buying difficult. While ETF Consulting found that fixed‑interest ETFs had a slow start after launch earlier this year, the report said they are likely to gain popularity.

Is it possible for both bonds and shares to fall at the same time?

Yes, although it’s uncommon. The article notes there have been occasions—such as in 1994—when market conditions caused both shares and bonds to fall. But historically since the global financial crisis, bonds have often risen when shares have fallen, providing diversification benefits.