Over the past decade, growth stocks have garnered more popular attention as equity markets have been favorable and attractive, while bonds have traditionally generated a more stable and modest return. However, although this market is little known, even the victim of a certain lack of attention, it is big enough to compete with, if not surpass, the stock markets.
You may know that bonds are used in portfolio management to generate income. They generally represent a very safe component of the latter since they are associated with capital protection. Unless you have a dynamic growth type investor profile, you most likely, without perhaps even knowing it, have exposure to the bond markets since the combination of bonds and equities is traditionally used as a basis for asset diversification. .
For example, if you invest in so-called “balanced” mutual funds, the fixed income is weighted generally between 40 and 50%. Thus, the more you have a cautious profile, the more you invest directly or indirectly in bonds. But what do you know, exactly?
Some basics
If stocks are equity securities in the growth of a company, bonds are essentially debt securities, which allow governments as well as private companies to finance specific projects or their day-to-day activities. Bonds trade and pay regular interest income (coupons) over the term of the bond and preserve the original capital until maturity.
Bond quality is a key concept to remember when looking at this market. Indeed, the capital will be recovered at maturity, conditional on the solvency of the issuer: a government bond is thus safer than a high-yield corporate bond. It is thus possible to take advantage of additional risk-taking: this potential return must, however, be accompanied by an analysis of the credit ratings assigned by the rating agencies.
You should also remember that bonds and coupons are traded on secondary markets. Active managers will thus buy and resell them before their maturity, and the market value of the bond will then depend on a mathematical formula whose main variables are the duration and the interest rate. The term of the bond influences supply and demand in this market. For example, short-dated bonds are normally less impacted by rising or falling interest rates.
If you hold bond funds or a balanced portfolio, you should therefore be interested in the average duration of the bonds that compose them. The shorter it is, the safer the investment will be. If you use several different securities or funds, it will be interesting that they do not offer the same duration, in order to diversify your risk.
However, a bond portfolio with a duration of two years does not mean that the average of its bonds will mature in two years. Yield to maturity is the best return indicator for a fixed income fund: it measures the average return on bonds in a portfolio if they were held to maturity (i.e. at maturity) and is highly representative of a return over a period of five years, which gives a good indicator of results for the investor.
A favorable environment
As you will have understood, while the operation of a bond is relatively simple, investing in this market requires an understanding of the behavior of the different types of fixed income securities in the different phases of the economic and stock market cycles. Since the value of a bond is inversely proportional to interest rates, the decline in bond markets in 2022 can easily be explained by the significant and rapid increases in key rates in the concerted and intensive fight against inflation.
Disappointed, since for the first time in a long time bonds did not play their compensating role for the volatility of the equity market, you may have directed your new investments towards GICs (guaranteed investment certificates), considering the rates of high interest offered on these products currently. While reassuring, this alternative to fixed income could cost you something in the short to medium term.
Indeed, you should remember that the possible drop in rates, and even the idea of a potential drop would, conversely, predict gains for the bond markets. According to various fixed income managers consulted recently, even if it is of course not possible to predict the exact moment when this will happen, because the rates are historically very high, the probabilities that the bond market will outperform in the next months are also. Moreover, in the past, bonds have held up well during periods of recession, offering a real alternative to the equity market, which was not the case in 2022.
In short, if bonds are often the unloved of a portfolio, they nonetheless make up a substantial part of it, so much so that the complexity of this market should encourage the investor to adopt an approach of diversification and management of risks. You now understand why it is imperative to take an interest in these markets in the current economic context. For the portion of your portfolio with a medium to long-term horizon, you don’t want to miss the upside, regardless of the guaranteed product.