Over the previous two weeks we have discussed the various types of bonds and how they work. Last week we examined in excruciating detail how bond prices are determined (extra credit if you read all the way to the end). Today we look at the role of bonds in reducing the risk of a well-constructed portfolio.
The concept of diversification is largely intuitive: distributing investment risk among several asset classes so as to reduce the overall risk of the entire portfolio. Generally, we turn to bonds (especially investment grade bonds) to provide a low-risk anchor to tether the other investments in the portfolio. The recommended allocation to fixed income depends upon investor-specific factors such as age, time to retirement and personal level of risk aversion.
Aside from cash, high-grade bonds provide the greatest degree of safety and predictability over time. In exchange for this relatively low risk, they offer very modest returns. This is not to say they are without risk: inflation erodes the real return, and rising interest rates diminish the present value of current bond holdings. But we generally consider the risk of significant capital loss with investment grade bonds to be minimal.
U.S. government bonds, as well as the sovereign debt of other major developed nations, are often considered to be “risk-free” in terms of the likelihood of repayment. Treasury bonds are backed by the full faith and credit of the U.S. government and are assumed to carry infinitesimal default risk. As such, they also offer the lowest rate of return (current 10-year Treasury bonds yield a whopping 2.3 percent, barely above the average inflation rate).
Christopher HopkinsInvestment-grade corporate bonds benefit from both the stellar creditworthiness of their issuing companies as well as their preferential rank within the pecking order of all investors in the company.