What role do bonds play now?

Bonds have traditionally been used to help balance out riskier investments, such as shares. That’s because they can provide income, help spread risk and often react differently to shares in the same economic conditions.

But this hasn’t always been the case in recent years. In 2022, high inflation and rising interest rates put pressure on both bonds and shares. This led some investors to question whether bonds could still play their traditional role in a diversified portfolio.

So, do bonds still have a role to play? Let’s take a look.

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First, what is a bond?

A bond is a loan made to a government or company.

When you buy a bond, you’re lending money to the issuer. In return, the issuer usually agrees to pay you interest over a set period and repay the original amount at the end of the bond’s term. The interest payments, known as coupons, are usually regular and fixed - hence why bonds are sometimes described as “fixed income”. 

The final repayment date is known as the bond’s maturity date. Put simply, it’s the date the loan is due to be paid back.

Unlike shares, bonds do not give you ownership of a business. You are a lender rather than a shareholder.

Many bonds can also be bought and sold before they mature. Their price can move up and down in the market, just like other investments. If you sell before the bond matures, you may get back less than you originally invested.

What made investors question the role of bonds?

Bonds struggled in 2022 mainly because inflation and interest rates rose sharply.

High interest rates are typically bad for bonds. This is because a bond’s payments are fixed, and these payments become less attractive when higher returns are available elsewhere. For example, if savings accounts start offering higher interest rates, investors may be less willing to buy a bond with lower fixed payments. And as demand for the bond falls, its price is likely to fall too.

This is where yield matters. A bond’s yield is a way of showing how much income it offers compared with its current price.

Bond prices and yields usually move in opposite directions - a bit like a seesaw. When bond prices fall, yields rise. When bond prices rise, yields fall. 

Imagine a bond that pays annual income of £50 and is priced at £1,000, giving it a yield of 5%. The £50 payment is fixed. However, the price of the bond can change. If the price falls to £800, for example, its yield rises to 6.25%, making it more attractive to potential buyers. 

So, while rising interest rates pushed many bond prices down, they also pushed yields up. Many bonds now offer higher levels of income than investors were used to when interest rates were very low.

That does not remove the risks. Bond prices can still fall, and issuers can fail to make payments. But investors are now being paid more for taking those risks than they were a few years ago.

Do bonds still diversify a portfolio?

Yes, but investors need to be realistic about what diversification can and cannot do.

Diversification means spreading your money across different types of investments, industries and parts of the world. It does not mean one type of investment will always rise when another falls.

That was the lesson from 2022. Bonds and shares both fell because markets were worried about the same thing: high inflation and rising interest rates.

This doesn’t mean bonds shouldn’t play a role in diversification. It’s more that investors shouldn’t rely too heavily on any single type of investment or assume that a traditional 60/40 split between shares and bonds will always provide the level of protection they expect.

So, what role do bonds play now?

Bonds can still play a useful role, but investors may need to think about them in a more practical way. Here are some of the roles they can play.

• They can provide income.
  Many bonds pay regular interest. With yields now higher than they were for much of the past decade, that income is now more meaningful. Unlike dividends, which companies can reduce or cancel, bond payments are a contractual obligation and must be paid unless the issuer defaults. This can be very valuable in retirement, when you may be living off regular income from your investments.
• They can help manage risk.
  Bonds issued by financially strong governments and companies are generally considered lower risk than shares, although they can still fall in value, particularly when interest rates rise.
• They can add balance.
  Bonds may not protect portfolios in every market environment, but they can still reduce reliance on shares alone. This can be useful for investors who want growth potential but do not want all their money exposed to equity market ups and downs.
• They can offer more certainty than shares.
  If you hold an individual bond to maturity, you usually know when it is due to be repaid, how much you are expected to receive back at maturity, and what income it is expected to pay, assuming the issuer can meet its obligations. Shares are less predictable because dividends and prices can change.
• They can sit between cash and shares.
  Cash is useful for short-term needs and emergencies, but inflation can reduce its spending power over time. Shares offer greater long-term growth potential, but with more ups and downs. Bonds can sit between the two, with more risk than cash but usually less risk than shares.

A note of caution… not all bonds behave the same way

The word ‘bonds’ covers a wide range of investments and they don’t all behave in the same way.

Investors often use government bonds for stability and diversification. Corporate bonds usually offer higher yields than comparable government bonds, but they come with a greater risk that the borrower cannot pay back what it owes. This is known as credit risk.

Some bonds, known as high-yield bonds, offer higher income but come with higher risk. They are issued by companies considered more likely to miss payments, so they can behave more like shares during difficult market conditions.

There are also index-linked bonds, where payments and/or the repayment amount are linked to inflation. These can help protect investors when inflation rises, but their prices can still move up and down.

The type of bond matters. A portfolio holding short-dated government bonds may behave very differently from one holding longer-dated corporate or high-yield bonds.

Diversification still matters

Bonds still have a place in many portfolios, but the argument for a simple 60/40 split between shares and bonds is not as clear-cut as it once was.

Investors need to think about how long they’re investing for, what they want to achieve and how much risk they feel comfortable taking. A well-diversified portfolio may include a mix of investments across different regions, sectors and asset types, including shares, bonds, funds, cash and, where appropriate, alternatives.

The key point is balance. Bonds are not risk-free, and they will not protect a portfolio in every market environment. But they can still provide income, help manage risk and reduce reliance on shares alone.

For long-term investors, that can still make them a useful part of a diversified portfolio.

• Read: What is diversification? The basics
• Read: Your 10 most-asked bond questions, answered
• Read: Can shares live with rising bond yields?

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the Fund investing in them. Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds. Tax treatment depends on individual circumstances and all tax rules may change in the future. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.