Should I ditch my low earning, but ‘safe’ investments?

I’ve always been advised to hold a proportion of my investment portfolio in bonds. When I questioned the low earnings recently the answer has been that, (a) the returns would improve as interest rates dropped, and, (b) bonds are required to balance the overall portfolio.

With the sharemarket now going gangbusters, I fail to understand how the low-earning bonds serve to balance a portfolio, apart from depressing the total value of my portfolio. Should I be retaining them?

Defensive assets such as bonds are useful in times of turmoil but can look unappealing when markets are booming.Credit: Simon Letch

Great question. Bond prices move in the opposite direction to interest rates, so when interest rates rose quickly in 2022 the value of bonds fell. The most common bond term is 10 years, but sometimes they can be longer, so bonds issued at 2 per cent during the pandemic are still floating around.

At today’s higher interest rates nobody is interested in buying a bond paying 2 per cent. The only way this bond can be sold is by offering it discounted. This discount is what you see in the bond portion of your portfolio.

Some important points to note. First, as with shares, the price reflects what the owner of the bond would receive if they were to sell. If instead they hang on through until maturity, they won’t have to accept a discount at all, and will get their full investment back, in the same way we as individuals might hold a term deposit.

Bond funds are required to report their current value, so they report what they would receive if their bonds were sold. It may, however, be that they hold it through to maturity. Thus, the loss never happens.

During the next down market, you might be glad for those bonds.

More importantly, looking forward, bond fund managers constantly have existing bonds that are maturing; they then reinvest those proceeds into new bonds. As bonds mature which had been paying low rates, and that money gets recycled into bonds at today’s higher rates, the portfolio’s return improves.

It is also true, as you have been advised, that just as bond prices fell when interest rates rose, if we see interest rates decline, as is already happening in most of the developed world, bond prices are likely to rise.

You will see in most advertising for financial products a statement to the effect “past performance is not an indicator of future performance”. This case is a great example. Bonds fell in value because interest rates rose sharply in an attempt to rein in COVID-related inflation.

But that story is behind us now. The future for bonds looks quite reasonable. Higher interest rates will progressively flow through into bond portfolios, and any subsequent reduction in official interest rates may serve to boost the capital value as well.

A separate but related issue is your risk tolerance. Your bond allocation falls within the defensive part of your portfolio. You will have had a discussion with your adviser as to the level of risk you want in your portfolio, and that informs the allocation made to defensive assets.

Defensive assets are not just bonds, they may include things like term deposits and cash holdings as well. You might wish to consider whether your current allocation to defensive assets remains appropriate. Just be wary of recency bias.

Sharemarkets have had a fantastic 18 months, and the outlook right now is optimistic. But historically markets have fallen about one in every four years. During the next down market, you might be glad for those bonds.

Paul Benson is a Certified Financial Planner at Guidance Financial Services. He hosts the What’s Possible? and Financial Autonomy podcasts. Questions to: [e-mail]

• Advice given in this article is general in nature and not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.

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