What role do bonds play in a portfolio?

Since the evolution of the modern bond market, investors have used bonds as a way of diversifying their portfolio, generating income and preserving their capital. Some even use the bond market as a capital appreciation tool.

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Since the evolution of the modern bond market, investors have used bonds as a way to diversify their portfolios, generate income and preserve capital. Some even use the bond market as a capital appreciation tool.

The Role of Bonds in a Portfolio

Investors include bonds in their investment portfolios for a range of reasons including income generation, capital preservation, capital appreciation and as a hedge against economic slowdown. In this section, we look at each in turn.

  • Income generation
    Bonds provide investors with a source of income in the form of coupon payments, which are typically paid quarterly, twice yearly or annually. The investor can use the income generated by their investments for spending or reinvestment. Shares also provide income in the form of dividends: however, such payments are less certain and tend to be less than bond coupons.
  • Capital preservation
    Unlike stocks, the principal value of a bond is returned to the investor in full at maturity. This can make bonds attractive to risk-averse investors who are concerned about losing their capital.
  • Capital appreciation
    Although bonds are often viewed as a capital preservation tool, they also offer opportunities for capital appreciation. This occurs when investors take advantage of rising bond prices by selling their holdings prior to maturity on the secondary market. This is often referred to as investing for total return and is one of the more popular bond investment strategies.
  • Hedge against economic slowdown
    While investors in stocks typically do not welcome a slowdown in economic growth, it can be a good thing for bond investors. This is because a slower growth usually leads to lower inflation, which makes bond income more attractive. An economic slowdown may also be negative for company profits and stock market returns, adding to the attractiveness of bond income during such a time.
View our case study focusing on volatility in the bond market and the role of bonds in a growth portfolio. View case study

Diversifying with Bonds

Bonds are considered a defensive asset class because they are typically less volatile than some other asset classes such as stocks. Many investors include bonds in their portfolio as a source of diversification to help reduce volatility and overall portfolio risk.

The chart below shows the historical volatility of different asset classes – including bonds and stocks – over recent decades. The bars above the horizon (zero line) show gains, while bars below the horizon reflect losses. You can see from the chart that bonds have a different return profile than stocks, offering the potential for greater stability of returns.

return profiles

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Disclosures

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.

Duration is, generally, a more accurate measure for small changes in interest rates. For larger interest rate changes, other factors may also impact a bond’s price.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2022, PIMCO.

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