Bond Investment Strategy-Reasons to Invest in Bonds | Harris Fraser
Wealth Planning
23 July, 2020
Bond Investment Strategy-Reasons to Invest in Bonds

In recent years, there has been growing interest for bonds in the investment market and we believe two main reasons for this.  

Seizing Investment Opportunities in Bond Market
Firstly, there is the risk of the economic recession and heightened volatility in the equity market. By investing in the bond market, investors can diversify risk, and potentially reduce the volatility in the investment portfolio. Secondly, investors see the US entering a rate cut cycle. With rates going further lower, bonds will likely gain via price appreciation.

Mixing asset classes to improve risk-adjusted returns
Regardless of the extent of recession and the rate cut cycle, allocating a portion of the portfolio to bonds likely achieves the two goals above. First off, let’s see how investing in bonds can bring risk diversification to the portfolio. Traditionally, the correlation between the performance of bonds and stocks is lower than that of other assets, even showing negative correlation at times. Take the Bloomberg Barclays US Treasury Bond Index and the S&P 500 Index as an example, as at the end of June 2019, the 30-day correlation coefficient between the two is -0.44, out of a range of -1 to +1. A negative correlation means that when one asset falls, the other tends to rise. Thus, when the equity market crashes, bond prices will likely see gains simultaneously, which could hedge excess volatility in the portfolio. In addition, bear in mind that both bonds and stocks generate total return via coupons and dividends. Over a longer timeframe, investing in a negatively correlated hybrid portfolio will likely generate higher risk-adjusted returns.

Investment opportunities with rate cut expectations
Next, we will dive into why rate cuts in the US benefit bonds. Generally speaking, changes in the US interest rates are decided by the Federal Reserve adjusting the monetary policy, which guides market rates by limiting the upper and lower bounds of the local bank rates. Short-term rates are more sensitive to changes in the Fed fund rates, when the Fed cuts interest rates, short-term market interest rates tend to fall; long-term interest rates on the other hand are also affected by other factors, positively correlated to factors such as economic growth and inflation expectations. When the expected future investment return or inflation rate is higher, the market would require a higher interest return before they are willing to lock the funds in bonds. Historically, U.S. Treasury interest rates tend to fall in the rate cut cycles and rise during the rate hikes, as the central banks will implement interest rate cuts when growth is slowing, long-term interest rates often move in line with the interest rate cycles.

Falling interest rates makes bonds attractive
So how exactly is changing interest rates related to bond prices, one might have heard that the two move in opposite direction. When market interest rates rise, bond prices fall, and vice versa. While the gain or loss in bond prices can be calculated, to further simplify it, investing in bonds means you give up the potential return of the deployed capital if it was invested in other assets, which is the opportunity cost. Given a fixed coupon rate of the bond, when the market interest rate (floating rate) rises, the opportunity cost will rise, the attractiveness of holding this bond will decrease, the market will require this bond to provide a higher interest rate to compensate for the lost opportunities, which causes the bond price to fall; on the contrary, when the interest rate falls, the market would ask for a lower bond interest rates, existing bonds will become more attractive. Therefore, Fed rate cuts tend to be beneficial to bond prices.

All in all, investing in bonds on one hand improves the risk-adjusted return of the investment portfolio; on the other hand, it provides an opportunity to capture gains from potential central bank rate cuts. We shall look into the details of bond investment options and any other important matters in the next session.

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