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.

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 shares, the principal value of a bond is returned to the investor in full at maturity. This can make bonds attractive to security-minded 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 shares 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 is also usually negative for company profits and share 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 less volatile than other asset classes such as shares. 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 volatility of different asset classes – including bonds and shares – over different time periods. 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 to shares, offering greater stability of returns.