If you’ve glanced at your portfolio and pondered the meaning of “bonds,” this article will clarify this asset class and how it influences your returns.
As a low- to medium-risk investor, your portfolio likely includes a mix of ETFs that invest in both equities and bonds.
While equities—also referred to as stocks or shares—are commonly discussed and understood, bonds are often perceived as more complex and less covered in mainstream media.
However, the global bond market was valued at an impressive $33 trillion in 2022, making it a considerable contributor to your investment returns. Therefore, gaining insight into how bonds work is essential.
What is a Bond?
A bond essentially represents a loan from investors to a government or company. You can think of it as an IOU or a unit of debt. Bonds have various lifecycles, lasting from a few days to several decades.
Bonds are “issued” by governments or companies seeking to raise capital and are subsequently purchased by investors. Most bonds provide a fixed interest rate throughout their lifespan, known as a “coupon.” At maturity, the investor receives their original principal amount back.
There are also more complex bonds that give the issuer the option to buy back the bond at a designated point, but we won’t focus on those here.
Why Do Investors Buy Bonds?
Bonds are favored by investors for their ability to provide a stable and predictable income stream. This characteristic offers a less volatile return profile compared to equities, which can experience significant swings.
Consequently, bonds are popular among conservative investors and those nearing retirement who seek to minimize fluctuations in their portfolios.
However, it’s important to recognize that while income returns from bonds may be more consistent, their market prices can also fluctuate. Bond prices are especially sensitive to interest rates and inflation, which we will discuss further.
What are the Main Types of Bonds?
Bonds can be issued by either governments or corporations. Government bonds are used to finance public spending. You often hear in the news about government “borrowing,” which they accomplish by issuing bonds. Some examples include UK gilts, US treasuries, and German bunds.
Corporate bonds, on the other hand, help businesses finance various needs such as projects, expansions, and debts. These are generally considered riskier than government bonds but tend to offer higher returns as compensation.
How are Bonds Priced?
When purchasing an equity share, your primary concern is usually its price appreciation. In contrast, when buying a bond, several factors come into play. The income component makes calculating bond returns slightly complex.
Coupon:
The coupon is the annual fixed interest rate a bond pays after being issued. This amount remains constant, which is why bonds are termed “fixed income” assets. If interest rates rise or fall, newly issued bonds will have adjusted coupon rates, but existing bonds will continue to provide the same coupon payments.
Price:
When a bond is initially issued, say at £100, that’s referred to as primary market issuance. However, in the secondary market, the bond may trade at a different price based on investor demand. Various factors will influence the bond’s attractiveness, including its yield, the issuer’s credit rating, inflation, interest rates, and more.
The most crucial factor is the interest rate set by the country’s central bank. For example, in 2022, swift interest rate hikes caused old bonds with lower rates to lose value, resulting in price declines.
Yield:
The yield of an existing bond represents the annual return on the bond. A simple way to calculate yield is to divide the coupon income by the market price of the bond. Since prices and yields are inversely related, when a bond’s price rises, its yield decreases.
The yield offers a comprehensive view of a bond’s relative value. Investors typically compare bonds with the same maturity term because term length and credit quality significantly drive bond pricing.
For instance, if you have a 10-year US government bond with a 4% yield and a 10-year corporate bond with a 6% yield, the 2% difference—known as the “credit spread”—is the premium you earn for taking on the additional risk of lending to a corporation rather than the government. However, if the government bond has a 30-year maturity and the corporate bond only five years, the comparison becomes less direct.
Credit spreads help investors compare the value of different bonds and assess sectors within the bond market. If spreads widen, one sector may be outperforming another; narrowing spreads could suggest the opposite.
Understanding Credit Ratings
Just as your creditworthiness affects your loan options, the same principle applies to bond issuers. Bonds receive ratings from specialized agencies, with AAA being the highest, indicating a strong likelihood of repayment. Bonds rated between AAA and BBB are classified as “investment grade” (lower risk), while those rated BB and below are deemed “high yield,” indicating speculative risks with higher default probabilities, but higher yields as compensation. High-yield bonds are sometimes referred to as “junk bonds.”
In general, government bonds from developed countries have a low risk of default and receive good credit ratings, as these governments are considered reliable lenders with stable tax bases.
The US bond market, the largest globally, is heavily composed of US government bonds, which are regarded as low risk and serve as a benchmark for the bond market. The yields on US government bonds inform how riskier bonds are priced and provide insight into whether investors are leaning towards “risk on” or “risk off” positions.
In emerging markets, where political stability can be an issue, government bonds typically have lower credit ratings, leading to higher yields to attract investors.
Emerging markets issue bonds in local currencies and major currencies like the US dollar. Local currency bonds may be riskier due to currency fluctuations, while dollar-denominated bonds are generally seen as more stable. Last year, any movements in the dollar had a significant impact on these emerging markets.
The Yield Curve and Its Significance
You may have encountered the term “yield curve.” This graph illustrates the yields of bonds with the same credit quality across different maturities. The curve’s shape often reflects the bond market’s outlook regarding the economy’s health.
A normal yield curve shows that longer-term bonds usually yield higher returns than short-term bonds, compensating for increased uncertainty over longer periods.
However, when the yield curve inverts, short-term bond yields exceed long-term yields. This inversion can signal changes in monetary policy by central banks, investor pessimism regarding the short-term economic outlook, or even the onset of a recession.
Analysts, economists, and investors worldwide closely monitor the yield curve as an indicator of potential market shifts.
The Role of Bonds in Nutmeg Portfolios
Bonds—both government and corporate—are essential components of our low- to medium-risk portfolios. They provide a stable income source and help offset equity market volatility.
Our investment team dedicates significant time to researching and selecting bond ETFs for our portfolios. If you’re interested in the specific bond ETFs we use, click here.
Bond Performance Update
In 2022, the bond market faced challenges as rising interest rates led to falling prices. It was a challenging year for bonds as central banks moved away from a prolonged period of low interest rates. However, this environment also means that starting bond yields are now higher.
At the beginning of 2023, we predicted a potential revival for the bond market, hinging on two main factors: the end of central bank tightening cycles and inflation returning to more manageable levels.
Recent events, including the collapse of several smaller US banks amid rising interest rates and declining bond prices, have raised questions about the central banks’ willingness to continue their rate hikes. There are concerns that the costs associated with combating inflation may outweigh the benefits, possibly leading to more banking instability.
This uncertainty has temporarily created volatility in the government bond market.
Currently, Nutmeg’s portfolios are cautiously positioned and slightly underweight in both bonds and equities. Our medium-risk portfolios recently increased exposure to corporate bonds where we see promising opportunities, and we find certain high-yield bonds selectively attractive for higher-risk portfolios.
Our investment team remains vigilant, monitoring the macroeconomic landscape and rebalancing portfolios as necessary to ensure appropriate diversification across various asset classes, regions, and sectors.
Want to Learn More?
If you’re interested in exploring bonds further or understanding other asset classes in your portfolio, visit our website for more insights and regular updates from our investment team.
Risk Warning
As with all investments, your capital is at risk. The value of your Nutmeg portfolio may fluctuate, and you might receive less than your initial investment. Past performance is not a reliable indicator of future results. Tax treatment depends on your individual circumstances and may be subject to change.
Let me know if you need any further adjustments or additional information!