Most private investors understand stocks and shares. They know that if they put their money in the stock market they are investing in the fortunes of individual companies and the wider economy.
They also know that stock markets can be volatile in the short run, but should beat most rival investments over the longer term.
Bonds are a bit harder to grasp. The bond market is huge, but you never hear about it on the evening news.
Nobody will ever slip you a “hot” bond tip. Nor do people regret failing to buy a bond, in the way they may regret shunning, say, Amazon or Apple 20 years ago, before their stock went ballistic.
Whisper it, but bonds are also boring. So why even bother if stocks and shares give you a better return over the longer run anyway?
Tuan Phan, a board member of SimplyFI.org, a non-profit community of UAE investment enthusiasts, says you still need bonds in your portfolio because they offer one thing shares never will – stability. “Stock markets are extremely volatile and could rise or fall anything up to 50 per cent in a year.”
That scares people, particularly in retirement, as a 50 per cent drop in the value of your assets could be a serious blow and shrink the amount of income you have for essentials.
Bonds, also called fixed-income investments, pay a set rate of return, known as a coupon, which you can reinvest for growth while still working, then take to top up your income after you retire.
There are two main types: government bonds such as US Treasuries, and corporate bonds. Both are issued to raise money – either to fund government spending or the company’s growth.
Mr Phan says stocks and bonds perform different roles at different times in your life. “You use stocks and shares to build your wealth when you are younger, and bonds to preserve it when you get older.”
This means you need greater exposure to stock market growth in your 30s, 40s and 50s, when you have time to build wealth and recover from any setbacks, then increase your bond exposure as retirement looms.
Young investors may only want 10 or 20 per cent of their portfolio in bonds, but this should rise over time, Mr Phan says. “Many people believe they can stand a 100 per cent equity portfolio even in a market downturn, but this isn't easy in practice.”
In retirement, Mr Phan says your bond exposure should rise to a maximum of 60 per cent, giving you steady income and a cushion against a market crash. “You don’t want to sell stocks to fund your income after markets have fallen, as that will rapidly deplete your portfolio without any chance to recover.”
Mr Phan argues that because bonds are designed to preserve your capital, most investors should largely hold government bonds and be wary of riskier types. You can secure a higher rate of interest from other types of bonds, for example, emerging market bonds, which are issued by governments and companies in developing countries, or high yield “junk bonds”, also called non-investment-grade bonds, typically issued by riskier companies with less of a track record.
Mr Phan argues that they are too volatile for most investors and in some cases their risk profile can be similar to stocks and shares.
He is a fan of low-cost index tracking exchange traded funds (ETFs) and tips iShares Global Govt Bond UCITS ETF (IGLO) iShares Core Global Aggregate Bond UCITS ETF (AGGG), and his personal favourite, USD Treasury Bond UCITS ETF (VDTY). “That invests 100 per cent in US Treasuries and pays monthly dividends, fantastic for giving a steady monthly income in retirement," he adds.
Stuart Ritchie, director of wealth management at AES International, says blending bonds with stocks should guard against the temptation to panic and sell stocks when markets crash. "Bonds stabilise your portfolio and this helps people last the course.”
Bonds are “negatively correlated” to shares, which means that when one goes up, the other typically goes down. “Diversification minimises volatility, which is particularly important if you need to draw money from the portfolio,” says Mr Ritchie.
Bonds also offer a more reliable fixed-income stream, while company dividends are not guaranteed, and can be cut or even scrapped if a company runs into difficulties. “Bonds should also return your full capital at the end of their term,” Mr Ritchie adds.
If your retirement portfolio is large enough you may only have to generate income of 4 or 5 per cent a year to fund your retirement. “A 50/50 split between bonds and equities limits volatility but still allows you to benefit from long-term stock market growth.”
Mr Ritchie also tips bond ETFs, and recommends you include some lower risk corporate bond funds alongside government bonds in your portfolio to generate higher income. His favoured funds include iShares Index Linked Gilts (INXG), iShares Core Corporate Bond (SLXX), iShares UK Gilts 0-5 Years (IGLS), as well as Vanguard Government Bond Index and Vanguard Global Short-Term Bond Index Fund.
Gordon Robertson, director of financial advisory group InvestMe Financial Services in Dubai, says that as a rough benchmark, your portfolio should be invested 65 per cent in stocks and 35 per cent in bonds. “This limits risk but achieves similar returns to pure stocks.”
The resulting combination of bond coupons and equity dividends should give you steady cash flow throughout retirement, while guarding against uncertain markets.
Mr Robertson says an old rule of thumb stating that your bond exposure should match your age is not out of date. This meant that at 40 you should have 40 per cent of your savings in bonds, rising to 60 per cent at 60, and so on.
As we live longer, possibly spending 25 years or more in retirement, you need to retain more stock market exposure. "This is particularly important with bond yields still at a historical low,” Mr Robertson adds.
Bond yields have fallen sharply since the financial crisis, for example, iShares Global Govt Bond UCITS ETF yields just 1.19 per cent and iShares Core Corporate Bond yields 2.63 per cent, although USD Treasury Bond UCITS ETF does better at 3.16 per cent.
These are hardly dazzling rates of return, only marginally better than you will get on cash although you may also get capital growth over time, as bond values rise.
Also remember that bonds do not offer you guaranteed 100 per cent security, as bond values can also fall.
This typically happens when interest rates rise, which makes fixed-income investments look less attractive. This worried many as the US Federal Reserve chair Jerome Powell pushed through regular rate hikes, but there are signs he is now going to move at a slower pace.
This offers some breathing space for bonds. Bond funds have a place in your portfolio but don’t forget they are not a completely cast-iron investment. Nothing is.