The Importance of Bonds for Your Investment Portfolio - dummies

The Importance of Bonds for Your Investment Portfolio

By David Stevenson

For many reasons, many institutional investors prefer to use bonds as a better indicator of wider macro signals and risk measures, rather than shares. Bonds and especially government securities tend to react very quickly to the macro-economic signals and risk measures.

Bonds are largely regarded as being lower-risk investments than shares, which is why they’re so popular with big institutions such as pension funds and central banks. Huge numbers of bonds have been issued, which means that bond markets are extremely liquid (lots of buyers, sellers and securities), deep and global. Bonds are also hugely popular with hedge funds because trading costs are low and transparency high.

Implementing an investment strategy using macro-economic signals, even one based around risk, is relatively easy ‒ at least in theory:

  1. Buy shares if you think the economy is booming and growth rates are heading upwards, and then stock up on commodities as inflation intensifies.

  2. Sell stocks and commodities as growth stalls and start buying bonds, especially government gilts.

  3. Start buying shares again as the recession bottoms out, on the expectation that growth is going to resume.

But perfect synchronicity doesn’t exist between markets and economic signals and that many managers are slow in responding to clear signals about, say, risk. Also, equity markets try to get ahead of any move upwards in the economy; that is, they’re probably about six months ahead of any firm data indicating an economic recovery.

In reality, a great deal of informational noise – much of it contradictory and potentially misleading – surrounds risk, macro signals and financial assets. Equities in particular can be very volatile and sometimes share prices are moved by factors that have nothing to do with interest, inflation or GDP growth rates, or economic/business cycles.

For instance, investors sometimes get worried about legislation and its impact on a particular sector or they get excited by the prospect of a massive increase in merger and acquisition (M&A) activity.

Bond investors are very influenced by macro signals, reacting in a fairly synchronised way to measures that suggest a downturn is on its way or inflation is about to increase. Macro-economic signals that indicate a recession are usually positive for bond pricing whereas inflation is bad news for bond prices.

Here’s a very simplistic explanation for this tendency: central banks attempt to keep their economies on an even keel, and they use macro-economic indicators to plan economic policy. When the economy begins to stall, central banks will buy bonds as a way to inject cash into the economy.

In so doing, interest rates will fall, bond prices will increase (because of the increased demand) and more businesses and people will begin to buy and invest. Conversely, when central banks need to remove cash from the economy to control rising inflation, they will sell bonds, which increases interest rates, reduces demand and pushes down prices, thus reducing inflation.

For these reasons bonds are an important component for macro-economic investing: First, they’re the proverbial canary in the coal mine: by watching what’s happening in the bond market, you can get an early indicator of what’s going on in the market as a whole – info that you can use when designing your strategy. Second, they form a key part of a diversified investment portfolio.