Should you bond with bonds?

With rising inflation and interest rates, besides global economic slowdown, this traditional sanctuary during turbulent stock markets deserves your careful consideration

By Udayan Ray

Published: Fri 19 Aug 2022, 11:05 PM

Like passengers dreading air pockets in flights, investors dread stock market turbulence. Prolonged market volatility for the better part of this year has given rise to clamour for greater stability and mostly dislodged the ‘Fear Of Missing Out’ (FOMO) mindset prevalent in the last two years when markets scaled dizzy new highs.

Not surprisingly, experts are suggesting a host of steps with a prominent suggestion being investments in bonds. Bonds are the traditional go-to investments when investors seek calmer waters compared to the choppy seas of equity markets. So, should you bond with bonds? The answer is not as straightforward as it normally is amid rising inflation and interest rates across the globe, besides an economic slowdown.

Bonds’ alluring promise of stability

Just in case you associate the word “Bond” with images of the dashing fictional British master spy, James Bond, thanks to books and movies, or you have a vague or no idea of what bonds are, here is a primer to help take our discussion ahead.

Bonds 101: Put simply, bonds are like loans extended by investors to institutions such as the government, municipality, corporations, among others. In return, the borrowers or bond issuers pay interest periodically, often twice a year. Contrast this with equity investments where investors, in plain speak, get a share of the profits in proportion to the ownership.

The bond interest rate can be fixed or variable with the loan amount, typically referred to as its face or par value, returned at the end of the bond term. Banks and financial institutions offer fixed deposits, which have the same features we have described so far. The key difference that bonds bring to the table is they are listed and traded in markets. This enables you to sell the bond before maturity and also buy bonds. Barring a mishap with the issuer, if you hold the bond till maturity, you not only get the interest or coupon payments during the term but also the principal amount.

Things become less straightforward if you decide to sell the bond before maturity. The price of the bond keeps moving during the term before maturity and depends on a host of factors, typically risk factors, that we will shortly discuss. Thus, compared to a fixed deposit (FD), the value of bond investment fluctuates during the term, constituting a risk if you exit before maturity.

Sources of income from bonds: You have two sources of income from bonds: interest and capital appreciation. Unlike stocks, where income from dividends is not committed, regular interest payment is an obligation of the issuing institution.

How bonds help in volatile markets

Bond prices witness fluctuations like stock prices, but they can help you during turbulent equity markets and in other ways.

Lower volatility advantage: Fluctuations in bond prices are typically nowhere near as pronounced or prolonged as stock prices. Thus, when you migrate some of your investments in bonds, you are likely to experience far lesser fluctuations in overall returns from your investments.

Income edge: Regular income from interest payments, typically the more significant part of bond returns, lends stability to the overall returns from investments that you seek. This stability eventually helps you save ample amounts for major goals like children’s higher education. The income generating feature helps you meet regular income needs, such as those in retirement.

Rebalancing and de-risking tools: When growth investments like equities sharply run up in a short period, like they did recently, you unknowingly assume more risk. Fixed income investments, such as those in bonds help you pare the exposure to excess risk.

Similarly, as you approach important goals, you need to secure your gains from growth investments by investing in lower risk investments. Shorter term bonds can play this role of low risk, parking slot effectively.

Given the various benefits of bonds, investing in them in volatile markets should be an “open and shut case”. However, prevailing economic conditions of rising inflation and interest rates along with a global economic slowdown call for informed investments after careful consideration of various factors, especially risks.

See through the illusion of ‘low risk’

A common misconception about debt investments like bonds relates to their being ‘low risk’. The truth is that they have different risks compared to equities and the danger for investors is not recognising the not so apparent risks. Let us take a closer look.

Risk of interest rate movements: As interest rates rise, as is the case now, bonds prices fall, and vice versa. This means that for the individual investor the best way to benefit from bond investments would be to focus on interest income. But that is easier said than done.

Long-term bonds offer higher rates but experience price fluctuations which reduce on nearing maturity. Thus, one way of pursuing high paying bonds, as some online bond trading platforms now hard sell, can be done with long-term bonds. Ironically, they introduce volatility that you want to escape.

Repayment risk: If the expected global economic slowdown increases, there would be companies, and even countries, who could default on payment of bond interest and principal. Thus, the repayment or credit risk that always exists in bonds, will get enhanced.

To be sure, credit rating agencies rate the risk of bonds to guide investors. At the same time, the emerging conditions will make it difficult to pursue high income growth from high interest bonds since these bonds typically have low ratings due to higher credit risk. You will need to restrict yourself to lower risk, lower paying highest rated and “investment grade” bonds. The harsh reality is that as with stocks, and in bonds too, higher returns come with higher risk.

Reinvestment risk: During a period of rising inflation, a bond offering a fixed rate of interest becomes progressively unattractive and experiences a decline in prices. The reason: increasingly new bonds with progressively higher rates are offered. Then, there is the double whammy of an exit hurting you due to lower bond prices and staying invested till maturity preventing you from benefitting from rising rates. You will face the same issue while re-investing maturity proceeds.

Inflation risk: We have already discussed how rising inflation and a hike in interest to contain inflationary fires adversely affect the value of bonds. In the long term, returns from bonds typically lag inflation quite significantly. Thus, informed, and prudent bond investing can help stabilise returns but not help you save large sums. So, do not get suckered by people who sell you any “low risk, high returns investment” story.

Given the bond basics and the emerging ground realities, here is an action plan that can help you use bonds to your advantage.

Your bonds action plan

Determine the objective: Do not invest in bonds simply as a knee-jerk reaction to stock market turbulence. Identify the role they will play in your financial goals like a child’s future.

Build a bond portfolio: Like equities, for debt investments like bonds too, you need to spread your investment eggs across many baskets. Among other things, investments need to vary across maturity periods and risk levels from different issuers like lower risk, lower return, government bonds and higher risk, higher return, corporate bonds.

Choose bonds to be held till maturity: This will be key in delivering the stability in returns you seek. Else, look for attractive bonds that can be held for the long term. In Dubai, this would mean taking a closer look at options such as National Bonds.

Consider floating rate and inflation-indexed bonds: Floating rate bonds dynamically adjust their interest rates according to prevailing interest rates. Their rates are typically benchmarked to market-determined rates, such as short-term government bonds. Due to its dynamic adjustment feature, interest rates can be lower than fixed rate bonds. In a period of rapidly rising interest rates, its rates run the risk of lagging behind inflation. Next, in the case of a call option in the bond i.e., the option for the issuer to retire the bond ahead of its maturity, will create risk of reinvestment.

Inflation-indexed bonds, which are typically issued by the governments and popular in countries like the US. Here, the face or par value of the bond adjusts with the inflation rate. Since the interest or coupon payment is likely to be linked to the face value of the bond, the interest payment could rise as well.

While being government issued, they have exceptionally low credit risk, due to their dynamic adjustment feature, the interest rates are likely to be lower than regular bonds. Such bonds help manage risks through diversification of your bond portfolio. Expats in Dubai can also consider such bonds available in their home countries.

Adopt a ‘barbell strategy’: This is a two-pronged strategy of selecting bonds. First, consider highly-rated, short-term bonds. This will ensure that you do not get adversely affected by high inflation and interest rate hikes besides volatility from long-term bonds. These bonds could also serve as a parking slot for past excess equity investments, helping you see through market turbulence. They will also help you reinvest maturing bonds in subsequently higher paying bonds. Such bonds can combine with long-term bonds held to maturity. Given the twin focus on short and long ends of the spectrum, this strategy is referred to as the “barbell strategy”.

Create a ‘bond ladder’: Keep investing in bonds over regular intervals to take advantage of rising rates from newer bonds. Subsequently, you can repeat the procedure while reinvesting bond maturity proceeds. This will create a regular income flow in the future and is known as the “bond ladder”. This is a useful tool to meet periodic expenses especially in retirement, such as home repairs and replacement of key medical devices like hearing aids.

Adopt a ‘bullet strategy’: This involves buying bonds of different maturities but maturing at the same time. So, purely for the sake of illustration, over the next few years, you buy five-, four- and three-year bonds all maturing in 2027. Such investments could be earmarked for a need such as home down payment.

From our suggestions, it would be amply clear that bond investing takes some doing and is a hands-on process much like stocks investing. The question is do you really have the time, inclination, and expertise for all this? Just in case you think your limited quality time is better spent with your family, you have the option of getting the job done by investing in bond funds and debt Exchange Traded Funds (ETFs), albeit for a small fee.

Consider bond funds and ETFs: In the case of bond funds, where investors’ money is invested in various bonds, fund managers not only manage various risks but also try to exploit the conditions to ensure you get the capital gains by buying and selling bonds. Even in a bond portfolio created and managed by you, bond funds can add more diversification and aid containment of risks. Of course, given the unprecedented economic conditions, there will be the risk of fund managers shooting off target.

Consider floating rate bond funds and inflation indexed bond funds that invest globally, besides implementing barbell, ladder, and bullet strategies with different bond funds. For better results, you can consider taking the help of a financial advisor with high credibility and integrity.

You can receive similar benefits from investments in debt ETFs. Here, investors’ money is invested in debt securities, typically bonds whether in a country or across the globe, in the same proportion as the index being tracked. Many debt securities in the index ensure automatic diversification and management of risk.

During the current period of challenging economic conditions, investment playbooks are getting rewritten. Bond investing is no exception. At the same time, they can continue to play a crucial role in your finances whether you invest in them directly or indirectly through mutual funds.

However, like all investments, you need to know how to use these handy tools.

So, are you ready to bond with bonds?

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