Are Bonds Still A Good Investment
Let’s take a trip back into history. It is 1972 and we are just getting attracted to investments. A good friend of yours advises you to invest in the UK stock market.
Thus, with the help of a broker and cash of $100,000, you build a portfolio of stocks with high ROI. All is well thus far.
Fast forward to 1974 (just barely two years of investing), you wake up to hear that the UK stock market has fallen by -72%. Thus, your $100,000 investment is now worth $32,000. There is a crisis. There is panic.
It is for the sake of such panic that bonds tend to save us from, usually in times of crisis. Bonds are “shock absorbers”. To some extent, it does not only protect but also helps us take advantage of crises.
In times when there is a stock market crash or market downturn, there is usually sudden movement of money from stocks into government bonds. It is almost as if investors seek refuge in bonds when markets crash. This is what is often referred to as “the flight to quality”.
What are bonds?
A bond is simply a financial vehicle through which a government (and sometimes companies) borrow money locally at a fixed interest rate. In other words, by buying a bond, you are indirectly loaning money to the government at a fixed interest rate for a fixed time.
Though the return on investment (ROI) on bonds is generally lower than that of the stock market, they are usually safer than stocks.
However, not all bonds are the same. There are three (3) types of bonds, largely based on bond market interest rates and their reaction in stock market crashes.
Short: They may offer less protection from a stock market crash (in a diversified portfolio), but are generally more resistant to rising market interest rates.
Long: Have a “high risk, high return” nature like stocks depending on whether bond interest rates are high or low. A high interest rate will mean high losses, while low interest rates mean low losses (high gains).
Intermediate: Typically a combination of short and long bonds. It finds a midway in the two bonds.
No matter the style or form of a bond, most initial capital losses are likely to be recovered eventually, because bond fund managers usually pay and reinvest interests earned. That means, as bond fund managers sell old bonds to buy new ones in the future, your earned interests will probably benefit from reinvestment into future less expensive bonds.
Popular instances where bonds saved situations:
During the dotcom crash from 2000 to 2002, while UK equities dropped -41%, the gilts (bond) gained 14%.
On March 6th, 2009, during the Financial Crises in 2008-2009, the World ETF fell by -37%. Yet, the Gilts moved up by 14%.
The recent Coronavirus pandemic ruined many stock markets. On March 23rd, 2020, the iShares MSCI World ETF, for instance, recorded a -26% fall. Meanwhile, on the same day, the iShares Core UK Gilts ETF rose 4%.
Do Bond Markets Crash?
The answer is rarely, though possible.
The success (or failure) of the bond market, usually depends on whether bond market interest rates are rising or falling.
Bonds usually make capital gains when the market interest rates fall. On the other hand, bonds take a capital loss when market interest rates rise.
What If The Bond Market Crashes Soon?
Now, in August 2021, market interest rates for bonds are still quite low. Nonetheless, things can change – and they always do. Governments and businesses tend to borrow more when interest rates are low. Experts around the world predict market interest rates to rise soon. Could this spell “danger”? Well, not really. There are two reasons why:
The bond market crash has always been expected for – over a decade:
This is not to say it cannot happen anytime soon. However, if it never did for over 10 years, what makes the few years ahead different, especially when interest rates are still declining? Even if they should crash, there will still be enough time for most weak bonds to enjoy some runway.
Bond Market Crises Are Usually Mild:
If we are to compare the relatively massive effects of a stock market crash to that of a bond market, the difference is always huge and clear – the latter is like a burp after dinner.
With that said, here are a few tips to ensure an almost “foolproof” bond asset:
1. Buy locally, and/or hedge to local currency: A foreign government bond may perform better than a local one, but investing directly in such a bond may have one major challenge – volatility due to currency conversions. It is important to look out for reasonable local government bonds. When necessary, consider some high-quality government bonds from other global sources or a low-cost index that holds gilts.
2. Think Intermediate Bonds: Considering the nature of both long and short bonds, an intermediate bond fund is a bit fair by serving as a buffer should there be a crash. A diversified portfolio with 5%-10% intermediate bonds and gold is could be that leverage for you in a downturn.
3. Treat Bonds As You Would An Insurance Policy: Insurance is a good thing, largely. However, it is not advisable to use 100% of your cash on insurance. The same applies to bonds. Ideally, they should not be more than 40% of your portfolio. The idea is to take advantage of fast-rising assets such as stocks in your portfolio while relying on bonds and/or commodities as insurance should the stock market crash.
To conclude, are bonds a good investment? Yes, because you can rely on them for some protection from the stock market and other commodity market crashes. It is not a bad idea to include bonds in your diversified portfolio to give it that balance it needs while taking full advantage of every possibility therein.
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