The value of bonds as a tactical investment
Having a balanced portfolio can help make portfolios more risk resistant and allow them to succeed in numerous market cycles. Bonds are one of the most valuable tools investors have to diversify and balance their portfolio. In this month’s blog, we explain what bonds are, how they are traded, why they fluctuate, and most importantly how they can help your portfolio.
What are bonds?
Governments and corporations often need to raise money for their operations. These operations can include anything from building infrastructure to launching new products. One of the ways a company or government can raise that money is by issuing bonds. Bonds are effectively IOUs whose face value, the principal, must be repaid on a maturity date. Bonds also include a coupon, which is the interest investors will earn from the bond and which is calculated annually as a percentage of the principal.
The four types of bonds are corporate, government, municipal, and mortgage. Though they are often considered safe investments, their prices can fluctuate for several reasons.
Bonds on the Secondary Market
Similar to the way stocks are traded, after a bond is issued on the primary market, it can be traded between investors on the secondary market, especially corporate bonds. Because of the variety of issuers and maturity dates, secondary market bonds are sold over the counter (OTC) instead of on an exchange.
The value of having access to a secondary market is that it gives bonds liquidity, which can be a very valuable addition to their secure reputation.
Why the fluctuations?
There are three primary reasons bonds may fluctuate: interest rates, the inflation rate, and economic outlook.
Interest rates and bond prices have an inverse relationship, meaning that when interest rates fall, bond prices rise, and vice-versa. This occurs because, if interest rates rise above a bond’s coupon, purchasing that bond will no longer be an attractive investment. Because potential investors could receive a better rate from banks, there will be less demand for bonds on the secondary market.
The inflation rate also has an inverse relationship with bond prices. Because a rise in the inflation rate means a decrease in a given dollar’s purchasing power, it means that if inflation rates rise more than expected, the return from a bond will be worth less in current dollars. However, the inverse is also true and can lead to a greater-than-anticipated purchasing power from the dollars returned by a bond.
Economic reports and outlook that can affect bonds include the employment rate and GDP growth, among other forecasts. And these forecasts can be the greatest force for fluctuating the bond market, as hope or fear influence investors’ decisions about future investments. If the numbers being reported are much better or much worse than what was expected, a big move in the bond market, as in most markets, can be expected.
Because bonds are seen as a safe investment, during volatile times or when there is negative economic news, investment-grade bond prices will rise. High-yield bonds often have more risk and therefore do not behave in the same way. Investors respect the safety of investment-grade bonds and may therefore choose them over investments with greater risk. On the other hand, when the economy is booming and there is good employment data, bond prices may suffer as investors seek to cash in on the greater market’s success.
How this affects you
At Rothenberg, we take a conservative approach to investing. Our Balanced Portfolio philosophy means that we aim to make our clients’ portfolios successful by matching it to their risk tolerance level and hopefully creating stable growth. Investment-grade bonds are a valuable tool in a balanced portfolio.
To learn how bonds can be useful to your specific portfolio, make an appointment with one of our Wealth Management Advisors. Please call 514-934-0586 (Quebec) or 1-800-456-0949 (Alberta).
