When it comes to investing, most people immediately think about stocks. The reason for this is simple – stocks are one of the most alluring investments with their profile in the media and potential to deliver returns several times of the initial investment.
This is why you often hear people talking about hot stock tips with co-workers or contemplating the next "Apple" with friends rather than mulling over the next big bond issue.
This doesn't mean you should exclude bonds from your portfolio altogether. Here are three important reasons why you should allocate part of your investment portfolio to bonds.
One of the critical success factors for an investment portfolio to prevail against market volatility over the long-term is diversification. When you diversify, you are ensuring your entire portfolio is not at risk of simultaneously under-performing, due to isolated or unexpected circumstances.
For example, you do not want to be caught in a situation where most of your investments are concentrated in a single industry, such as the oil and gas companies, which most likely willunderperform all at once when oil prices weaken.
The same concept applies to investing in different asset classes. During economic downturns, the stock market may witness wild fluctuations. This is when sovereign bonds or bonds issued by high quality companies can become attractive for investors looking for a safe haven to park their money – to continue to grow their money or to see it decline at a slower rate than other investments.
As the demand for high quality bonds increase, these bonds may enjoy an appreciation in value. This may help investors offset some of their losses incurred due to a decline in their stock investments. As a result, investors are able to enjoy portfolios that are more resilient to economic cycles.
Even within bond investments, it's important to ensure sufficient diversification among the bonds you invest in. Similarly, you want to avoid concentrating investments in any particular sector or geographical region, as one or two unexpected events can quickly lead to a simultaneous decline of the value of these bonds.
#2 Steady stream of income
When a company isn't profitable or want to retain profits in order to continue growing, its management has the discretion to reduce or not declare any dividends to its shareholders. This makes it difficult for many stock investors to accurately estimate the income they can expect to receive from their stock investments. This is particularly a problem if they rely on this income to upkeep their lifestyles or reinvestment plans.
Unlike dividends from stocks, companies that issue bonds are legally obliged to provide payouts at regular intervals in the form of coupon payments. This is regardless of whether or not they are profitable for the period.
Most bonds are issued with a coupon payment. The coupon payment usually represents the returns that one will receive from the bond issuer for each period. For example, a corporate bond with a 5% annual coupon means that the bond issuer will pay out $500 each year for every $10,000 that a bondholder invests in.
This makes bonds an attractive option for investors who want to enjoy a regular stream of income. As long as the company that issues the bond does not default, bond investors will receive the coupon payment promised to them.
#3 Conservative investors
All investors have differing risk appetite and tolerance.
For example, some investors want to grow their wealth slowly over time and are averse to sustaining losses, even in the short-term. They may find stock investments too risky and may prefer allocating more of their money to bonds to reduce the chance of their portfolio value experiencing large price swings.
With all things being equal, an investment made into the bond of a company will always be considered safer compared to same investment being made into its stock. This is because even if the company does not perform to expectations, bondholders will be paid their coupon payments. Moreover, in the event the company ends up being liquidated, bondholders will be earlier in line to be repaid the amount due to them compared to shareholders, who will only receive whatever is left after all debts have been repaid.
This isn't to say that bondholders will never lose money in the event of a default, but that their losses are generally expected to be less compared to that of shareholders.
Don't Ignore Bonds
Since they are not as extensively covered in the media or investment analysts, bonds tend to be overlooked by many retail investors. However, as discussed, excluding bonds from your investment portfolio may put it at greater risk of losses and volatility.