Capital Ideas^TM

Building a resilient and balanced portfolio should be a priority for many investors in today’s environment of heightened financial market uncertainty and volatility across a range of asset classes, including equities. With that in mind, now’s a perfect time to revisit the question: Why fixed income when the yields are extremely low? Fixed income serves four key roles in a portfolio: capital preservation, income generation, inflation protection and diversification away from equities. Many investors would benefit from evaluating whether their bond holdings are meeting these goals.

Not all bonds are born equal

The bond market is large in terms of size and number of issuers, with a variety of instruments each with distinct features to meet the needs of different investors.

The potential benefits of investing in bonds are:

1. 
   
2. Capital preservation
3. Income generation
4. Inflation protection
5. Diversification away from equities

The different fixed income asset classes such as developed and emerging market government bonds, investment grade and high yield corporate bonds and inflation linked bonds, are designed to meet different investment needs as shown in the chart below. For example, relative to the other asset classes, global treasury bonds can offer attractive diversification benefits given their longer duration position, and the relatively low volatility makes this asset class ideal for capital preservation. On the other hand, high yield and emerging market bonds are better suited towards fulfilling the role of income generation, given the higher nominal yield present in these markets.

1. Capital preservation

An allocation to bonds represents the anchor of a durable and resilient portfolio as it can provide stability in times of uncertainty.

Even in the low yield environment we have been experiencing for years, fixed income has fulfilled its role of capital preservation. Despite potential short-term mark-to-market losses, over the medium term (3 years) bonds have always provided positive returns. This is due to the nature of the bond, which returns par value (US$100) at maturity unless a default scenario arises. The good news is that the historical default rate tends to be very low for high quality bonds and virtually zero for developed countries’ government bonds.

2. Income

It’s called fixed income for a reason.

Unlike equities, bonds carry more explicit and predictable income streams in the form of coupon payments to investors, so long as the issuer remains solvent. While the yield will fluctuate with the price, coupons on fixed rate bonds typically do not change. For this reason, bond funds provide some income, with higher yielding bonds generally associated with additional risk. This steady source of investment income can play an important role for many investors, such as retirees who may rely on it for monthly living expenses.

While income should be a component of any diversified portfolio, it is prudent to monitor the portion of a fixed income allocation dedicated to higher yielding bonds. Specifically, these holdings should not be regarded as a key source of capital preservation or diversification from equities — they may not perform those roles well.

 

1. Data as at 31 July 2021. Source: Bloomberg, JPMorgan. Market value in US$ billions. Date of inception is 31 July 2001 (31 July 2002 for Emerging Markets hard currency and 31 January 2006 for Emerging Markets local currency)

2. Source: Aladdin. Data as at 31 July 2021. IG: investment grade. HY: high yield. EMD emerging market debt. Tips: Treasury inflation-protected securities. *Capital preservation is based on the asset classes’ 5-year volatility

3. Source: Bloomberg. Data as at 31 July 2021

 

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
• Depending on the strategy, risks may be associated with investing in fixed income derivatives, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.