Introduction
Portfolio diversification is a fundamental principle of investing and is generally well-known. However, sometimes the rationale behind diversification gets overlooked. The purpose of diversification is to optimize returns relative to risk, given specific market conditions. Ultimately, this approach aims to deliver better risk-adjusted returns. Today, we’ll explore why returns from bond investments are less volatile than those from equities and how this contributes to portfolio stability.
Dissecting bond returns
Returns from any investment asset, whether equity or bonds, stem from two sources: (a) capital gains and (b) interim payouts, such as dividends or coupons (interest payments). In bonds, most returns come from accruals or coupon payments, thanks to a predefined maturity date and a fixed maturity amount. Consequently, bond market prices cannot deviate significantly from their face value, unlike other assets like equity. This results in less fluctuation in market price and, therefore, more stable returns.
Coupon payouts occur on specified dates, which may be monthly, quarterly, semi-annually, or annually, depending on the bond’s terms. Additionally, investors may realize capital gains by selling bonds before maturity at a price higher than the purchase price.
Role of bonds in portfolio diversification
In certain market conditions, equity and bond prices can move in opposite directions. This was briefly mentioned in the first paragraph: it’s about negative correlation. Although this correlation isn’t perfectly negative, any degree of it helps lower portfolio volatility and improve risk-adjusted returns. Let’s consider an example: In 2020, just before COVID-19, there was a substantial correction in the equity market. From January to March 23, 2020, major equity indices fell by approximately 38% before later rebounding significantly. During the correction, if your portfolio included bonds, which yielded positive returns, your portfolio would have been comparatively less volatile. Now, let’s examine the advantages of including bonds in your portfolio.
Advantages of allocation to bonds
Visibility of Returns: With an individual bond, the investor receives a defined return known as yield to maturity (YTM), representing the compounded annualized return if the bond is held until maturity. In a bond portfolio, such as a mutual fund, Portfolio Management Services (PMS), or Alternative Investment Fund (AIF), the YTM reflects the weighted average YTM of all bonds in the portfolio. These funds are perpetual, with individual bonds maturing periodically. Thus, the portfolio YTM offers a perspective on expected returns over a reasonable holding period. For example, consider a bond portfolio with a YTM of 10%, a weighted average maturity of 4 years. By holding this portfolio for around 4 years, you could expect approximately 10% annualized returns, subject to minor market price fluctuations.
Stability in Performance: In investing, it’s not only about final realized returns but also the smoothness of the journey. As mentioned earlier, a diversified portfolio that includes bonds provides better risk-adjusted returns. The Sharpe Ratio, a common metric, is calculated as portfolio return minus the risk-free rate, divided by portfolio standard deviation. In a portfolio with bond allocations, returns volatility (standard deviation) is typically lower, resulting in a higher Sharpe Ratio.
Suitability for Various Horizons: Volatile asset classes, like equities, generally require a long investment horizon to ride out market cycles. Bonds, however, are suitable for both short- and long-term horizons.
Periodic Cash Flows: Bond coupons are paid annually or at other intervals, such as monthly or quarterly, providing a predictable cash flow. Additionally, in a bond portfolio, bonds with varying maturities generate cash flows upon maturity, whether in 2 years, 5 years, or beyond. In other asset classes, generating cash flows often requires liquidating part of the portfolio. With bond allocations, however, portions of the portfolio naturally generate liquidity.
Returns Potential: Conventional wisdom suggests that bond portfolio returns are lower than equities. However, the reality is more nuanced. Investment-grade bonds and portfolios can deliver double-digit returns. While equity returns have been particularly strong over the past year, there’s no guarantee they will sustain these levels in the future.
Conclusion
While other asset categories like gold or real estate can diversify a portfolio, equities and bonds remain the core asset classes. Since bonds provide stable returns and predictable cash flows, you may consider allocating a substantial portion of your portfolio to them, depending on your investment objectives.
Disclaimer - Investments in debt securities / municipal debt securities / securitized debt instruments are subject to risks including delay and/ or default in payment. Read all the offer related documents carefully.