Bonds (also called fixed-interest investments) are usually touted as one of the bet ways to hedge your portfolio in case the share market crashes or the economy goes into recession (or both).
In fact, if you talk to any American investor you will probably hear the term '60/40 Portfolio'. This is the classic portfolio structure that many investors are advised to follow in the US. It involves a 60% allocation to stocks coupled with a 40% allocation to bonds and fixed-interest.
Whilst bonds have never been as popular back in Australia, many investors still carry some bonds as insurance. But is this still a good strategy to follow?
What are bonds?
Bonds are essentially loans that you buy off the lender in exchange for a (usually) fixed interest rate and loan length. The most common type of bond on the retail market is a government bond (loan to the government), which are also considered ultra-safe (as the government can't really run out of money). There are corporate bonds out there, but most 'average' investors stick to government bonds as companies can default and not have to pay back your money.
Why are bonds used as a hedge?
Bonds are normally considered safer than shares for the above reasons, and in times gone by would normally pay a decent inflation-beating yield. Even three or four years ago, a government bond would have paid around a 4% interest rate, which is a lot more attractive than a dividend-paying share for many investors
Because of this safety, in a market crash, investors often pile into bonds to protect their capital. This pushed the prices of bonds up at a time when shares might be falling, ensuring that a portion of your portfolio is growing when your shares might be falling.
What's the problem with bonds then?
Due to the record low interest rates we have seen over this year, the yields on bonds are also at record lows. To illustrate, a 10-year Australian government bond is today paying a coupon rate under 1%, which doesn't even cover inflation.
Bond prices are already very high, and if a recession/market crash does happen, it might well push bond yields into negative territory – we have already seen this in Japan and Germany recently. We are in uncharted waters on this, but I'm not entirely convinced of the merits of holding negative-yielding bonds at any time.
Foolish takeaway
If you're still set on owning bonds as a hedge, by all means do so. But I personally think the ability of bonds to protect your portfolio has been highly compromised in this era of low interest rates and bonds have become a risky asset class in itself. I'm personally not bothering, but to each their own!
