Corentin Scavée
14 Mar 2024
Bonds, an essential ingredient of a balanced portfolio
Bonds are often considered the simplest and most accessible investment product. By analogy to Maslow's pyramid of needs, if a "pyramid of investments" were to be established, bonds would undoubtedly constitute a form of primary need: a prerequisite for any other form of investment.
What is a bond?
A bond most generally defines a loan issued by a government or a company, offering a fixed interest rate over a fixed period, with the promise of reimbursement at maturity.
A financial antiquity
Bonds have existed since Roman times when they defined a legal bond under which one person was bound to another to perform a financial obligation. This obligation was also called in Latin "ob-ligatus", literally "close bond", describing a strong relationship between two people. Ultimately, the term "bond" has survived in English, overriding "obligation" which still applies in French.
The most popular investment in the world
In 2020, the sum of all outstanding bonds amounted to € 110 trillion, 30% more than the total value of global equities at the time. They are made up of 68% government bonds and 32% corporate bonds.
A guarantee of security that reassures
The stable interest rate, most generally fixed, and the promise of repayment at maturity provide security for the investor, making it possible to generate a secure income while taking a low risk. It is for this reason that the bond is considered the basic investment product, a kind of "primary investment".
No reimbursement guarantee but priority over shareholders
One should be aware that bonds are not a completely risk-free product. If the borrower is unable to repay, you may lose some or all of your investment. However, it is generally much less risky than stocks. On the one hand, because the value of a bond remains more stable and reacts to a lesser extent to changes in the economic situation of a company or a state. On the other hand, because the holder of a bond has priority and is reimbursed before the shareholder in the event of bankruptcy.
How is the rate for a bond set?
Each Central Bank periodically determines a daily rate, called the “funds rate”, at which it remunerates commercial bank deposits that it has received. This rate is used as a benchmark for setting bond interest rates, also called "coupons". Depending on the economic and financial situation of the issuer of a bond and its presumed repayment capacity, an additional interest is added to the funds rate to remunerate the investor for the additional risk incurred. This increase is called the “risk premium”.
A higher interest implies a higher risk
There is no high return without risk. This adage also applies to bonds. A bond with a high interest rate will therefore present a greater risk of loss than one with a lower rate. Rigorous assessment of this risk is a complex task in which companies called rating agencies have specialized themselves. They assign a rating to each bond and this rating makes it possible to quickly assess the risk incurred and to easily compare the bonds with one another.
Government bonds are generally safer
Typically, government bonds carry lower interest rates than bonds issued by private companies. They offer greater repayment guarantees, a State being more sustainable and having quite easily the possibility of inflating its debt and its revenues to repay the loans coming to maturity.
Liquid market, fluctuating value
Just like with stocks, there is a bond market where you can buy or sell bonds to other investors before maturity. The price at which bonds are exchanged is fixed there by the law of supply and demand. As a result, the price of a bond can vary over time.
Do not confuse yield and bond rate
Due to price fluctuations, an investor who buys a bond after its issue or who sells it before maturity is likely to obtain an annualized yield different from the interest rate offered by the bond. Indeed, the interest paid is based on the value of the bond when issued while the yield is calculated on based on the actual buying and selling prices. Only an investor who buys a bond when issued and holds it until maturity will earn a yield equal to the interest rate of the bond.
Central bank’s rate and prices move in the opposite direction
Since the funds rate set by the central bank serves as a benchmark for setting bond interest rates, an increase in this funds rate automatically leads to higher yield expectations among investors. In order to remain attractive, a bond in circulation offering a fixed rate sees its price adjust to compensate for the change in the key rate. A decrease in its price will indeed compensate for its lower rate and align its yield with investors' expectations.
A factor of stability
Due to their reduced sensitivity to the stock markets, bonds stabilize a portfolio by reducing its overall downside risk. Government bonds will in some cases even go so far as to partially offset the fall in equities. Indeed, in times of high uncertainty, investors protect themselves by purchasing assets that offer a form of capital protection, these assets are called safe-havens. Government bonds are one of those safe-havens and generally see their prices rise in times of crisis. There is thus a certain form of decorrelation between the stock market and government bonds.
Obligations: better a little or a lot than not at all
As we have seen, the very nature of bonds - low risk - make them an essential ingredient in any investment portfolio. Whether you have a rather defensive or rather offensive investor profile, bonds base remains essential to ward off the inevitable stock market fluctuations.
Moreover, easyvest's approach based on investing in trackers is a simple and efficient way to build broad exposure to stocks and bonds. Whether the portion of bonds in your portfolio is small or high, your portfolio with easyvest will include a large number of bonds, further reducing the overall risk.
How much bonds should you hold in your portfolio?
How much bonds you should hold in your portfolio will depend on your investment goals and your risk aversion. The shorter your horizon, the higher the share of bonds should be. Likewise, the higher your risk aversion, the more it will be necessary to hold bonds to reduce fluctuations of your portfolio. To determine precisely how much of bonds you should hold, we invite you to do your own simulation here.
Note: This article was written when Easyvest was authorized and regulated by the FSMA as an agent in banking and investment services.