Bonds are an asset class that you don't hear too much about these days. For the uninitiated, a bond is an investment the same way a share is. Many investors build what's known as a balanced portfolio using a combination of shares and bonds. Why? Well, bonds are perceived to have a different risk profile to shares. They tend to respond to market events in different ways. In this manner, bonds can provide a portfolio 'protection' against share market crashes and other volatility that shares have a habit of bringing into one's portfolio.
The name's Bond…
That's because (unlike a share) a bond is essentially a loan. It doesn't represent an ownership stake in a business. Instead, it's an obligation to be repaid a certain amount of capital (or principal), along with interest. That's why bonds are sometimes referred to as 'fixed interest investments'.
Bonds can be issued by all manner of institutions, including corporations and municipalities. But the most common and popular form of bonds are public or government-issued bonds. These are popular because the government of an advanced economy is considered a 'risk-free' lender. Since a government can't really go broke or bankrupt (a privilege that owning currency printing presses allows for), there is no real risk that if you lend your money to the government, it won't be repaid.
It's relatively easy to access these bonds as well for any ASX investor. There is a plethora of bond or fixed-interest exchange-traded funds (ETFs) on the ASX. Some popular examples include the Vanguard Australian Fixed Interest ETF (ASX: VAF) and the iShares Core Composite Bond ETF (ASX: IAF).
So this all sounds pretty good, right?
Well, I think there are a 2 very good reasons why you should avoid bonds and bond ETFs today.
Shaken, not stirred
Firstly, the interest you can expect from a fixed-interest ETF is paltry. Because interest rates are at record lows right around the world (0.25% in Australia right now), the interest governments have to pay on their loans are also very low. Consider this – an Australian Government 10-year bond is today offering an annual yield of 0.93%. That's less than what you can conceivably get from a bank savings account these days. Thus, having a large chunk of your portfolio in bonds right now is essentially dead money.
Secondly, interest rates are at record lows. Whilst this seems similar to what we just discussed, there's another way interest rates affect bonds. Bonds are priced according to interest rates. If a government issues a 10-year bond at 0.93% per annum, and the following year issued one at 2% per annum because interest rates rise, the latter bond becomes more valuable than the former. Thus, because interest rates are virtually zero, anyone holding fixed-interest investments today will see their value decline significantly if the government started raising interest rates at any time over the next few years. And because the Australian cash rate is at 0.25%, there's a lot more ceiling than floor – and thus a lot of risk, in my view.
Bonds used to be an effective asset class to diversify your portfolio, but the current financial environment makes them essentially impotent as an investment, in my view. Instead, it's my opinion that investors should be looking to diversify their portfolios in other ways for the foreseeable future. Perhaps a mix of sturdy dividend-paying shares is a good place to start.