The investment world is rough right now. The stock market is tanking, crypto winter is here, and even real estate seems to be coming off the boil. In times of crisis, investors often flock to what are known in the industry as ‘defensive’ assets, the most common of these being bonds.
So can bonds protect your investments from the crazy stock market we’re seeing at the moment?
You can get a heap of different types of bonds, but they almost all have one characteristic in common: when you invest in a bond, you are lending money to the organisation that has issued it.
The most common types of bonds are the ones issued by governments. Governments around the world don’t tend to have billions in cash sitting in the bank. When a big-ticket item comes up, they typically need to raise money to fund it somehow, and they often do it by issuing bonds.
Remember the Eat Out to Help Out Scheme? This was a post-lockdown deal where the government, through Chancellor Rishi Sunak, offered a 50% discount to anyone who went out to eat or drink in local restaurants and pubs. This scheme cost £849 million.
This is the type of project that the government will look to pay for by issuing bonds, and it works kind of like a fixed deposit that you get from the bank. For example, the government would offer up £849 million worth of government debt to the market, and agree to pay a set rate of interest over a set period of time. This might be, say, 2% per year, with the money returned to investors after ten years.
Bonds are as safe as the organisation issuing them. If it’s the UK or US government, that’s pretty safe. You can be almost certain that they will be able to keep paying your interest each month and will have the cash to pay you back at the end of the term.
Other issuers aren’t as secure. Countries with less-developed economies issue bonds, and so do companies. These will be higher risk, but as a tradeoff, they will offer higher returns as well.
Because bonds are backed by governments and companies that are generally pretty secure, bonds are considered to be less risky than shares. The returns usually aren’t as good over the long term, but they tend to fluctuate less.
There are higher-risk bonds, but even these are often backed by the physical assets of the organisation, just like a mortgage is backed by the security of the property. This is why they’re often referred to as a defensive asset.
That said, it doesn’t mean it’s always a good time to invest in bonds. Since they can be bought and sold on the open market just like shares can be bought and sold after their initial offering on the stock exchange, the value of the bonds on the market can move around if interest rates move. It can be a bit hard to get your head around, but the value of existing bonds actually goes the opposite way to interest rates. If rates go up, the value of your bonds goes down and vice versa.
Quick example to illustrate this: Say I buy £1,000 of Rishi’s bonds when interest rates are at 2%. That means I get a whopping £20 each year from my bonds. Now say that the Bank of England puts interest rates up to 4%.
This means that for any new bonds issued by Rishi, my £1,000 would get me £40. So why would anyone buy my bond for £1,000, which only pays £20? The answer is that they wouldn’t. In order to sell mine, I’d have to drop the price to £500 so that it now pays 4% to whoever buys it, matching what they can get directly from Rishi.
TL;DR - When interest rates are expected to go up a lot, that can be a bad time to invest in bonds in the short term.
Long term, bonds can be a good way to reduce the risk and volatility in your portfolio. If you’re planning on accessing your investments in 3-5 years, it probably makes sense to have a fair amount of your money in bonds.
Like any investment, though, trying to time the market is a bad idea. If you think you can quickly move your stock investment to bonds for a few months until the bleeding stops, you might be in for a rude shock. In the short term, right now, bonds probably can’t protect your investments. At least not entirely.
With inflation high and interest rates expected to go up almost everywhere in the world, it could mean bonds aren’t a great place to be in the short term. So just like any investment you’re considering, you should think about how bonds fit into your overall investment strategy and make sure you keep a long-term view.
Also Read: How to Invest in Funds and ETFs
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