Why Buy Bonds?Bonds
You should include bonds within your portfolio for many differing reasons. Bonds create profile stability, exceed cash returns, have a variety of choices and flavors, and diversify the risks of a portfolio.
Bonds enhance the stability of your portfolio. Equities move positively or negatively based on analyst estimations, economic reports, Federal Reserve rate changes, opinions, financial statements, and corporate news on a day to day basis. As investment instruments, equities can provide large returns, but are fairly unstable and have high volatility. Cash or savings instruments change based on bank lending rates and Federal reserves, but rarely offer returns close to the inflation rate.
Bonds sit in between these two extremes. They provide you with moderate returns while removing most of the volatility found within equity investments. When equity based markets are collapsing, bonds are still required to generate payments for bondholders. Your contract requiring payment of interest and principal still stands, assuming the issuer has not entered bankruptcy. If the issuer has been reduced to bankruptcy, bond contracts guarantee first rites to the company’s remains. You receive your share of recovered assets before preferred shareholders, and they receive their share before common shareholders. Because of this certainty, when equity markets collapse shareholders take a flight towards bond markets (or alternative investments such as commodities) to reduce principal erosion. As the equity markets recover, these bondholders shift capital from bonds back into the equity markets, accelerating their returns. Bonds are a perfect place to acquire a fixed rate of return when share prices are languishing.
As previously mentioned, Cash and cash based investments are the simplest investment alternative to both bonds and equities. You are unlikely to ever lose principal while invested in cash based instruments. In exchange for this stability cash instruments rarely ever have high rates of return. The result is that cash based instruments have the highest likelihood of below inflation level returns, their real rate of return is almost always negative. Bonds reduce this damage in two ways. Nominal bonds do not adjust to inflationary changes; to compensate they will have returns which are closer to inflation than cash instruments. You receive less real return loss in comparison to cash based instruments, and barely exceed inflation while having stability in equity market downturns. During periods of high inflation bonds will suffer real return losses. Fortunately, Governments issue many bonds, which automatically adjust for a constant real return, known as inflation adjusting bonds. These bonds adjust the principal paid at issue to the domestic inflation rate, and then continue to pay a fixed interest payment until the maturity of the bond. These bonds reduce your inflationary risk. Both bond types have rates of return which exceed cash or savings instruments by several percentage points.
Bonds could also arguably rival shares in the amount of options for selection or customization. Bonds come in a large variety of flavors each of which changes their potential risk and return for your portfolio. As previously stated, bonds are issued in inflation adjusting or nominal returns, but can divide into several categories. These include the following designations:
- Sovereign Issued
- Domestic or Foreign Issued
- Developed/First World
- Developing/Emerging Market
- Investment Grade
- High Yield
- And more
Each of these bonds has changing or varying amounts of risks and compensations for those risks. These differing characteristics grant you the ability to attune your portfolios towards varying levels of risk and return. You can mix these bond types to acquire levels of diversification you were previously completely unaware of, potentially creating a complete disconnection between your bond and equity portfolio.
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