FIXED INCOME EXPLAINED

Including bonds in your strategy increases diversification, which makes your portfolio more resilient. This is particularly relevant to investors who increased their stock exposure in recent years in response to low interest rates.

Diversification explained

A diversified portfolio is one that spreads risk by investing in various assets, such as bonds and equities. The key to this approach is investing in assets that are uncorrelated, meaning they react differently to changes in the economy.

Often, when interest rates are low, but the economy is growing, investors are encouraged to move into riskier sources of income and returns. For some, that means moving from bonds to stocks.

The downside is that these investors could have a high exposure to equity risk in their portfolios. In this scenario, the investor’s portfolio is less diversified and potentially more vulnerable to an equity market sell-off (the event of rapid selling of stocks due to market movements or political events).

Risk: Diversification and asset allocation may not fully protect you from market risk.

For a steady income stream, you have the option to invest in a mixture of bonds – some riskier, some less so. This provides diversification and can help to generate income without eroding your capital.

The spectrum of bonds

Income is a big reason why bonds have proven so popular with investors over the years. Both mutual funds and bond ETFs invest in a wide range of bonds, all of which seek to pay a fixed amount of interest.

Many investors want to target a regular income without denting their overall returns. To achieve this income, diversification and an awareness of risk is key. Bonds deemed less creditworthy usually offer a higher yield. On the other hand, bonds perceive to be safer generally yield less. Investing in a diversified portfolio of bonds, right across the fixed income spectrum, can offer greater potential to achieve income goals.

Risk: A main risk related to fixed income investing is credit risk. Credit risk refers to the possibility that the issuer of the bond will not be able to repay the principal and make interest payments.

Bonds are deemed less risky than stocks, because bondholders are repaid before shareholders if a company encounters financial problems. This makes them attractive to cautious investors who are seeking better returns than those available from cash.

Are bonds deemed less risky than equities?

Cautious investors who might not want to take a lot of risk with their capital often allocate part of their portfolios to fixed income. Unlike stocks, where the company does not promise to return your investment, bond issuers make a contractual promise to do so.

In addition, if a company enters financial difficulty, bondholders are repaid before shareholders. Many investors find the capital preservation and portfolio stability offered by fixed income attractive.

An alternative to cash

Another option available to risk-averse investors is to keep their money in cash. When investing in cash, it’s important to remember the risk of opportunity cost – that the returns from cash are lower than the returns available elsewhere. An allocation to high-quality and/or inflation-protected fixed income assets can offer an effective strategy to limit portfolio losses, while leaving room for capital appreciation.

Risk: The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.