3 Reasons To Add Bond Exposure To Your Investment Portfolio

By adding a bond exposure, we can improve the resilience of our portfolios while still maintaining our returns. By adding a bond exposure, we can improve the resilience of our portfolios while still maintaining our returns.

June 13, 2024

In the investment world, stocks often command more attention compared to bonds. This is because stocks, which represent ownership in a company, can have their value increase or decline significantly based on how well the company is doing. This potential for high returns—or significant losses—makes stocks particularly appealing to many investors.

Conversely, bonds are generally perceived as a safer investment compared to stocks. Bonds are loans that investors give to a bond issuer, which could be a company or a government entity. In return, there is a promise of regular interest payments, also known as coupon payments. These payments are fixed and do not change regardless of the bond issuer’s financial performance. Thus, even if a company excels, the interest it pays on the bonds that it has already issued will remain the same. Similarly, if a company struggles or incurs losses, it is still obligated to make these predetermined interest payments and to repay the principal amount at the bond's maturity.

However, the appeal of bonds extends beyond their reputation as a safer investment compared to stocks. Even investors who are inclined towards higher risk and potentially higher returns should consider the strategic benefits of including bonds in their portfolio. Here are three good reasons why we think investors should consider adding a bond exposure to their investment portfolio.

For many investors, generating passive income from their investments is important. Passive income can be used to cover expenses, reducing reliance on employment income. Bonds are a reliable source of stable passive income due to their fixed interest payments.

When we invest in a bond, we are lending money to the bond issuer, who, in turn, pays us periodic interest payments, known as coupon payments. Typically, bonds pay interest semi-annually, annually, or in some cases, quarterly. The interest rate, or coupon rate, is usually fixed at the time of issuance. For example, if we purchase a $1,000 bond with a 5% annual coupon rate, we will receive $50 in interest each year.

In addition to the interest payments, we also receive the principal amount, or face value, of the bond back when it reaches its maturity date. This repayment is in addition to the regular interest payments received over the bond's term.

While stocks can also provide passive income via dividends, it is important to recognise that dividend payments are not mandatory. A company has the discretion to reinvest its profits back into the business or retain its profits. In contrast, bond issuers are legally obliged to pay out interest payments in the form of coupons. This obligation makes bonds a more dependable source of passive income compared to stocks.

Even for those of us who invest primarily in stocks, having bond exposure can be valuable for our investment portfolio. This is due to the concept of inverse correlation between stocks and bonds.

Inverse correlation means that during periods of economic growth, when stock prices tend to increase more quickly, bond returns could be lower. Conversely, during economic downturns or recessions, corporate profits may decline, and the stock market often becomes more volatile and less attractive. During such times, investors seek safer investments, making bonds a favourable option. This increased demand for bonds drives up their prices.

By having both stock and bond exposure in their portfolio, investors can reduce their overall portfolio risk and limit their losses, as these assets provide a natural hedge for each other. Bonds' stability and fixed interest payments offer a counterbalance to the volatility and potential high returns of stocks, creating a more resilient and balanced investment strategy.

The interest rate environment can significantly influence the attractiveness of bond investments. When interest rates are high, it becomes more expensive for companies to borrow and expand their business, making stock investing less attractive. Conversely, higher interest rates mean that new bonds will be issued with higher coupon rates, making them more attractive to investors seeking higher returns.

For example, in the current market environment, the US Federal Reserve (the Fed) is currently setting its interest rate for Federal Funds at 5.25% to 5.50%. Given that the Fed offers such attractive returns, it is unsurprising that many investors would prefer to invest in these relatively risk-free government bonds rather than attempting to earn a higher return in the stock market. This is why a higher interest rate environment tends to favour bonds over stocks.

As investors, we need to be aware of how changing financial markets can affect our investment returns and make informed investment decisions that will ensure the continuous growth of our portfolios. The right allocation between stocks and bonds can help us achieve our long-term investment goals by balancing risk and return effectively. By including bonds in our portfolio, we can create a more resilient portfolio that can withstand various economic conditions.

By now, most of us recognise the importance of diversification when investing in stocks. However, when it comes to investing in bonds, diversification is even more vital. Unlike stocks, where there is a chance of investing in companies that can generate exceptionally high returns, bond investments do not offer outsized returns. Instead, bond investments aim to generate stable income through coupon payments, ensure the return on initial capital, and build a portfolio that can perform well during both good and bad times. Therefore, it is crucial not to invest all our funds into just one or two bonds.

Given the high minimum amount often required to invest in individual retail bonds, diversifying our bond investments can be challenging. This is where bond ETFs (Exchange-Traded Funds) can play an important role in helping us gain exposure to a diversified portfolio of bonds.

By investing in bond ETFs, investors can efficiently diversify their bond holdings, ensuring a balanced approach to generating stable returns and preserving capital across various economic conditions. This strategy helps achieve long-term investment goals through diversification, mitigating the risks associated with investing in a limited number of individual bonds.

The fund manager, Nikko AM, also manages the ETF on our behalf, allowing us to take a hands-off approach to our bond investments.

Like all investments, bond ETFs carry risks that investors should consider before investing. One key risk to bear in mind when investing in bond ETFs is:

Please refer to the prospectus of the ABF Singapore Bond Index Fund and the Nikko AM SGD Investment Grade Corporate Bond ETF for further information of its investment risks.

It's important to note that investors should carefully consider these risks and conduct their own research before investing in any bond ETF. Investors should also assess their own investment goals, risk tolerance, and time horizon to determine if bond ETFs are a suitable investment for their portfolio.

* weighted average duration (years) measures the bond fund's price sensitivity to interest rate changes. Generally, the higher the weighted average duration of a bond fund, the more its price will be affected by interest rate changes.

This document is purely for informational purposes only with no consideration given to the specific investment objective, financial situation and particular needs of any specific person. It should not be relied upon as financial advice. Any securities mentioned herein are for illustration purposes only and should not be construed as a recommendation for investment. You should seek advice from a financial adviser before making any investment. In the event that you choose not to do so, you should consider whether the investment selected is suitable for you. Investments in funds are not deposits in, obligations of, or guaranteed or insured by Nikko Asset Management Asia Limited (“Nikko AM Asia”).

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