Bonds: Why quality matters

Some may assume that all investments sitting under the ‘bonds’ banner are stable, defensive and able to weather difficult economic conditions, but the reality is more nuanced than that.

In this article, I discuss how government bonds can provide secure income and capital preservation, the importance of liquidity in a crisis and why quality matters when it comes to constructing the defensive part of an investment portfolio.

Stable income and capital preservation, backed by governments

Television shows like ‘Grand Designs’ will never focus an episode on a building’s concrete foundations, they are simply unexciting, yet they are the solid base upon which everything else is built.

Government bonds play a similar role in portfolios, forming the solid foundation that supports a diversified portfolio. When an economic storm hits, a solid foundation is critical for a portfolio’s resilience, providing a hedge against the uncertainty of other investments that may have higher levels of risk and volatility. This is because government bonds are considered one of the safest investments available. They are backed by the full faith and credit of governments, making them a low-risk investment option.

Not all fixed income is created equal

Within the fixed income asset class, the riskier a bond issuer is, the greater the rate of income (known as the coupon rate) bond issuers need to pay to lenders to compensate them for their additional risk of default.

Lower-grade, higher-risk bonds look attractive given their incrementally higher returns, however, the coupon rate is only one aspect investors should consider. Careful selection and ongoing analysis is critical to avoid company defaults, which can result in the total loss of capital for investors.

At the other end of the spectrum, government bonds have minimal default risk, especially given governments can raise taxes, reduce spending or simply print more money to meet their financial obligations – options not available to corporations.

Government bonds typically go through periods where their popularity and total returns are more muted, and other stages, such as during crises and when central banks commence cutting rates, where demand and returns surge. Often experienced in short, sharp episodes of market activity, sitting on the sidelines and hoping to time the market can result in investors’ portfolios being ill-equipped to deal with, or prosper from, sudden changes.

Crisis liquidity

The benefits of government bonds, such as capital preservation, income generation and hedging against economic slowdown are well known, but ‘crisis liquidity’ is often overlooked due to the rarity of market crises. 

Liquidity can mean the difference between prospering and missing out during a market dislocation.

In our experience, the only certainty is uncertainty, and while other investments, such as corporate debt or hybrids can ‘lock up’ in a crisis (meaning they cannot be easily sold), an allocation to government bonds can be readily sold. This can help nimble investors to re-allocate capital toward discounted growth assets, such as equities, setting up the potential for meaningful returns once they recover to normal levels.

To that end, we expect and anticipate some outflows from our government bond funds during a crisis because that means we've successfully served our crisis liquidity role, helping our investors to capitalise on these rare opportunities.

Vital foundations

In our view, quality is a critical consideration when it comes to both security selection and portfolio construction. The decision to include bonds within a portfolio should not be taken on the basis of coupon rates alone, but should also consider what their inclusion can provide a portfolio in terms of its overall liquidity, total portfolio sensitivity to market crises and ability to provide stable income and capital preservation. Government bonds can act as a true diversifier against the riskier parts of a portfolio and as a source of income and liquidity when crisis events take place - making them a reliable choice for risk-averse investors.

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