The question I have been asked most often over the past year is: ‘Why do you own bonds?’
This may appear to be very simple, but many investors would struggle to provide a coherent or consistent answer. This partly reflects the vast range of investments covered by the word ‘bond’ (even if we ignore the old-fashioned single premium investment contract) as well as the variety in the structure of the asset.
In contrast, equities appear far simpler. Issued by companies, your claim sits at the bottom of the capital structure and you are entitled to all the cash flow in perpetuity, once other claims have been paid.
In a world where economic growth is the norm, equities provide an opportunity to benefit from a rising cash flow stream.
Bonds on the other hand are issued by a myriad of institutions, have varying places in the capital structure and are subject to specific conditions that may be different from other securities from the same issuer.
In addition, most bonds have a limited life and consequently the risk, potential returns and sensitivities of these bonds change through time.
When asked why one would hold bonds, it is legitimate to reply: 'Which bonds and when?'
Despite the complexity of the bond universe, many will reflexively answer the question on ownership with some variation on the theme of ‘for diversification’.
This deceptively simple answer hides great complexity that can cause confusion for investors, advisers and portfolio managers.
The rest of this article will therefore be focused on unpicking this complexity to help us better understand the potential role of bonds in a multi asset portfolio.
Why do investors need diversification?
Before focusing on bonds, it is worth thinking about the notion of diversification in general. The need for diversification reflects the fact that the future is uncertain and the path into the future is treacherous.
Human beings are poorly equipped to deal with uncertainty and tend to underestimate the range of possible outcomes it implies. Consequently, we tend to react strongly to situations that we perceive as a threat.
These strong reactions can prompt us to make poor decisions that left unchallenged could result in long-term harm to our financial wellbeing.
The best way to avoid these situations is to ensure that the surprises we experience as a result of changes in the price of our investments are not perceived as threats.
Diversification can achieve this by dampening the impact of equity price movements to the extent that we no longer consider these movements to be a threat and hence are more likely to make sound and thoughtful investment decisions.
