Bonds still have a role

Each week, a professional investor tells us where she'd put her money. This week:Alexis Gray, Vanguard Investment Strategy Group

Successful investing depends on many factors, some of which can't be controlled. At Vanguard, we believe the most effective way to achieve good long-term results is to focus on the things you can control. This means creating clear, appropriate investment goals, developing a suitable asset allocation strategy using broadly diversified funds, minimising costs, and maintaining perspective and long-term discipline, especially in times of uncertainty.

For example, equities tend to outperform government bonds over longer periods. The trade-off between the two asset classes is that equities provide growth to a portfolio, and bonds provide stability. Combining both asset classes together in a portfolio therefore allows investors to get the best of both worlds over time.

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However, with interest rates near zero and government bonds paying less than 1%, it's not overly surprising that the merits of continuing to invest in bonds are being questioned. After all, why would investors want to hold bonds in the current environment, rather than just keeping their savings in cash? Nonetheless, we believe that bonds can still offer a great deal of value in a portfolio, even with interest rates so low.

Bonds provide very important diversification benefits. They deliver a stable income stream over time, while also providing protection during times when the equity market is experiencing difficulties. It is true that increasing the share of cash in a portfolio can also dampen volatility, but cash provides no counterbalancing effect when equities fall in price, unlike bonds. Not only do bonds continue to generate income during difficult market conditions, but when investors move their money out of equities and into safer assets, you can expect to see bond prices pushed higher, helping to offset capital losses on equities. If we look at the UK market since November 2015, for example, it's been a pretty bumpy ride for equities. There have been sharp rises and falls resulting from bouts of uncertainty, which reflect concerns over the Chinese economy, worries about rising US interest rates, and most recently regarding Brexit.

There have been worries that a "bond bubble" is set to burst when central banks start raising interest rates. Of course, a rising-rate environment implies a healthy economy and higher income opportunities. Both of these developments are good for investors in the long term. However, some investors are concerned about the potential for losses on bonds as rates rise all else being equal, if interest rates go up, the price of existing bonds with lower yields falls. But it's worth remembering that for the long-term investor, yields and returns are not the same thing.

As yields rise in response to higher interest rates, the income that the investor receives from their existing bond holdings can be reinvested at a higher coupon rate than before. This means higher returns on these reinvested cash flows than would have been the case had rates remained at lower levels. As a result, overall returns on the investor's bond portfolio will gradually start to rise and will eventually converge with yields at a new, higher level than before.