Investors may normally associate bonds with low risk and low returns, and equities with higher risk and thus potentially higher returns. For investors who diversify their portfolio of funds using bonds, they will notice that returns from their bond funds fluctuate less than their equity funds. So why are bonds less volatile than equities? The answer lies in the difference between these 2 asset classes.
Bond Characteristics
Bondholders are lenders to a government or company that issues the bond. Bondholders are entitled to a coupon payment, which can either be paid semi-annually (once every six months) or annually. When the bond matures, the investor will get back the full principal amount. For example, if you have purchased a 4% coupon bond with a principal value of $1000, you will receive $40 annually. At the end of 10 years, you will receive $1000.
Since bonds represent loans made by investors to a particular company, bondholders are effectively creditors. They have the right of claim to assets of that company should it go bankrupt. That's why they focus on the credit worthiness of the company, or the ability of the company to finance its interest, and payment of its assets.
If a company is borrowing only a small amount, and makes more than enough revenue to finance its loan obligations, then bond investors will feel more secure in lending money to these companies (see the example later in the article). Companies that have valuable assets have stronger credibility with bond investors. Investors will be more willing to lend such companies money at lower interest rates. They know that even if the company runs into financial trouble, it has assets that can be liquidated to pay bondholders.
Differences Between Bonds & Equities
In comparison, equity holders take on different risks. A bond often trades close to its nominal value. You will rarely find a bond selling at two times of its nominal value. In contrast, a stock can easily trade for more than two times of its book value. A company's equity often trades at multiple times its yearly earnings. A company can typically trade at more than 10 times Price Earnings (PE) ratio. The PE ratio is often used to value a company. It measures the market value of a company's equity over its earnings. Hence, the future earnings of the company will often have a direct impact on a profitable company's share price. Equity investors actually base the price of the equities they own on the cumulative future earnings of the company. And since few investors believe that company will close down in the next few years, they often price its stock at a multiple of its earnings.
Although equity holders are taking on greater risk, they can potentially get a greater profit when earnings rise. The value of the company's stock actually increases with earnings, since the cumulative earnings that a company can expect to receive for the next couple of years is higher. In addition, equity holders may also receive dividends if the company is performing well. However, for bondholders, when earnings take an upturn, the coupon and the principal amount to be paid to investors upon maturity remains the same. This actually means that bondholders are missing out on the capital gains and dividend payout that come with holding equity.
What if the company's projected earnings come down? This will affect equity owners directly but not necessarily the bondholder. As long as the company is still capable of financing its debt, the bondholder is indifferent to the fact that earnings has come down.
This goes to the root of why the value of equities will be so much more volatile than the value of bonds. As a company may go from making a loss in one year, to making a huge profit in the next, its stock price will go through large swings. That's because equity holders are constantly reassessing the value of the stock based on what they can now expect it to be worth in relation to its future earnings. Whereas for bondholders, the returns they can receive from the bonds coupon payments, is already fixed. Their primary concern is whether the company can repay its all its loan obligations. As such, variation in corporate earnings have a much smaller impact, unless the company's fundamentals fail to such an extent that its ability to repay its loans becomes uncertain.
An easy way to see this would be to use an actual example. If a company earns 100 million every year, and uses 10% of that to pay the interest on its bonds, what happens if its earnings drop to 50 million? In such a situation, it is still able to repay its interest comfortably. Furthermore, if the company has $1 billion worth of assets such as land, etc, then bond holders have a claim to those assets, should the company default. This helps to reduce the bondholders risk. But to a stock investor of that same company, a drop of 50% in that company's earnings is likely to be very bad news. This directly affects the value of the stock. Hence, the stock price may fall sharply.
Bonds As A Diversification Tool
Bonds are good alternatives for conservative investors and for investors who are aggressive and wish to diversify their risk. Unlike equities where price follows an irregular trend, bond prices usually trade around their principal value. The reason bond prices fluctuate at all is because the price of a bond depends on future coupon payments and current interest rates. If interest rates are higher, bond prices will decrease, and vice versa if interest rates go lower. There are mathematical formulas that can be used to explain this. But simply put, as interest rates increase, the opportunity cost of holding a bond at a fixed coupon rate actually increases. For example, when interest rates for fixed deposits go up, you are comparatively better-off putting your funds in a fixed deposit. In such an environment, bonds will get cheaper over time.
However, interest rate movements matter less if you intend to hold the bond to maturity (you will receive fixed coupon payments during the life of the bond, and the principal payment upon maturity). In comparison, equities offer much less certainty. The price will generally fluctuate in line with the market and the fundamentals of the company. If the corporate earnings forecast declines rapidly, then stock prices will fall too.
Chart 1
Source: Bloomberg
In Chart 1, we compare the return between bond funds and a global equity index. In order to represent bonds as an asset class we used a composite index that included returns from OCBC Savers Global Bond Fund and the Deutsche Lion Bond Fund. These funds are invested in global bonds and Singapore bonds respectively. To represent equities, we used the MSCI World Index. The chart illustrates that bonds are less volatile than equities. From the 2000 to 2002 period, investors who have consistently diversified in both asset classes, would have lost less during that period. At the same time, conservative investors would have been able to preserve their capital as well.
Since bonds are relatively stable investments with fixed current income payments, why do people hesitate to invest? The reason may be that when markets are rallying, investors tend to be overly optimistic about the future performance, ignoring the importance of diversification. Another reason is that whenever there's news about interest rates moving up, people will tend to think that it is not a good time to buy bonds or bond funds. Investors should take note it is always useful to use bonds or bond funds for diversification. This applies in both bull and bear markets. For conservative investors they can consider bonds or bond funds as a useful tool to earn stable returns.
Chart 2
Source: Fundsupermart Compilations
Chart 2 shows how three different portfolios with $10,000 fare over time. The first portfolio includes a 100% equity fund portfolio, the second portfolio includes 60% equity and 40% bond funds, and lastly the bond portfolio includes 100% bond funds. From this chart, we observe that when investors include bond funds in their portfolio, the portfolio is much less volatile than an equity only portfolio. Thus, for an aggressive investor, investing in bonds is an effective way to diversify risk.
Conclusion
If you compare portfolios that comprise bond and equity funds, you will find that the former is always less volatile. The fundamental reason behind this is that bond investors are effectively debt holders of the company and have a claim to the assets of the company when the company goes bankrupt. Equity-holders do not have this advantage. This actually means that investors take on less risk when they invest in bonds. In addition, the volatility of bond prices will decrease when the bond is closer to maturity. As bonds mature, the debt holder will get back the full amount of the principal. This is unlike equities when prices are volatile there is actually no guaranteed amount that an investor can get back.
During strong market rallies, investors usually go into equities and forget about the importance of diversifying during a period of market downturn. During a market downturn, some investors start to regret not diversifying earlier. Thus, the advice that we would like to give to investors is to make use of the stability of bonds to diversify their portfolio. That would actually mean including bonds or bond funds in an equity portfolio, even if markets are rallying.
Bond Characteristics
Bondholders are lenders to a government or company that issues the bond. Bondholders are entitled to a coupon payment, which can either be paid semi-annually (once every six months) or annually. When the bond matures, the investor will get back the full principal amount. For example, if you have purchased a 4% coupon bond with a principal value of $1000, you will receive $40 annually. At the end of 10 years, you will receive $1000.
Since bonds represent loans made by investors to a particular company, bondholders are effectively creditors. They have the right of claim to assets of that company should it go bankrupt. That's why they focus on the credit worthiness of the company, or the ability of the company to finance its interest, and payment of its assets.
If a company is borrowing only a small amount, and makes more than enough revenue to finance its loan obligations, then bond investors will feel more secure in lending money to these companies (see the example later in the article). Companies that have valuable assets have stronger credibility with bond investors. Investors will be more willing to lend such companies money at lower interest rates. They know that even if the company runs into financial trouble, it has assets that can be liquidated to pay bondholders.
Differences Between Bonds & Equities
In comparison, equity holders take on different risks. A bond often trades close to its nominal value. You will rarely find a bond selling at two times of its nominal value. In contrast, a stock can easily trade for more than two times of its book value. A company's equity often trades at multiple times its yearly earnings. A company can typically trade at more than 10 times Price Earnings (PE) ratio. The PE ratio is often used to value a company. It measures the market value of a company's equity over its earnings. Hence, the future earnings of the company will often have a direct impact on a profitable company's share price. Equity investors actually base the price of the equities they own on the cumulative future earnings of the company. And since few investors believe that company will close down in the next few years, they often price its stock at a multiple of its earnings.
Although equity holders are taking on greater risk, they can potentially get a greater profit when earnings rise. The value of the company's stock actually increases with earnings, since the cumulative earnings that a company can expect to receive for the next couple of years is higher. In addition, equity holders may also receive dividends if the company is performing well. However, for bondholders, when earnings take an upturn, the coupon and the principal amount to be paid to investors upon maturity remains the same. This actually means that bondholders are missing out on the capital gains and dividend payout that come with holding equity.
What if the company's projected earnings come down? This will affect equity owners directly but not necessarily the bondholder. As long as the company is still capable of financing its debt, the bondholder is indifferent to the fact that earnings has come down.
This goes to the root of why the value of equities will be so much more volatile than the value of bonds. As a company may go from making a loss in one year, to making a huge profit in the next, its stock price will go through large swings. That's because equity holders are constantly reassessing the value of the stock based on what they can now expect it to be worth in relation to its future earnings. Whereas for bondholders, the returns they can receive from the bonds coupon payments, is already fixed. Their primary concern is whether the company can repay its all its loan obligations. As such, variation in corporate earnings have a much smaller impact, unless the company's fundamentals fail to such an extent that its ability to repay its loans becomes uncertain.
An easy way to see this would be to use an actual example. If a company earns 100 million every year, and uses 10% of that to pay the interest on its bonds, what happens if its earnings drop to 50 million? In such a situation, it is still able to repay its interest comfortably. Furthermore, if the company has $1 billion worth of assets such as land, etc, then bond holders have a claim to those assets, should the company default. This helps to reduce the bondholders risk. But to a stock investor of that same company, a drop of 50% in that company's earnings is likely to be very bad news. This directly affects the value of the stock. Hence, the stock price may fall sharply.
Bonds As A Diversification Tool
Bonds are good alternatives for conservative investors and for investors who are aggressive and wish to diversify their risk. Unlike equities where price follows an irregular trend, bond prices usually trade around their principal value. The reason bond prices fluctuate at all is because the price of a bond depends on future coupon payments and current interest rates. If interest rates are higher, bond prices will decrease, and vice versa if interest rates go lower. There are mathematical formulas that can be used to explain this. But simply put, as interest rates increase, the opportunity cost of holding a bond at a fixed coupon rate actually increases. For example, when interest rates for fixed deposits go up, you are comparatively better-off putting your funds in a fixed deposit. In such an environment, bonds will get cheaper over time.
However, interest rate movements matter less if you intend to hold the bond to maturity (you will receive fixed coupon payments during the life of the bond, and the principal payment upon maturity). In comparison, equities offer much less certainty. The price will generally fluctuate in line with the market and the fundamentals of the company. If the corporate earnings forecast declines rapidly, then stock prices will fall too.
Chart 1
Source: Bloomberg
In Chart 1, we compare the return between bond funds and a global equity index. In order to represent bonds as an asset class we used a composite index that included returns from OCBC Savers Global Bond Fund and the Deutsche Lion Bond Fund. These funds are invested in global bonds and Singapore bonds respectively. To represent equities, we used the MSCI World Index. The chart illustrates that bonds are less volatile than equities. From the 2000 to 2002 period, investors who have consistently diversified in both asset classes, would have lost less during that period. At the same time, conservative investors would have been able to preserve their capital as well.
Since bonds are relatively stable investments with fixed current income payments, why do people hesitate to invest? The reason may be that when markets are rallying, investors tend to be overly optimistic about the future performance, ignoring the importance of diversification. Another reason is that whenever there's news about interest rates moving up, people will tend to think that it is not a good time to buy bonds or bond funds. Investors should take note it is always useful to use bonds or bond funds for diversification. This applies in both bull and bear markets. For conservative investors they can consider bonds or bond funds as a useful tool to earn stable returns.
Chart 2
Source: Fundsupermart Compilations
Chart 2 shows how three different portfolios with $10,000 fare over time. The first portfolio includes a 100% equity fund portfolio, the second portfolio includes 60% equity and 40% bond funds, and lastly the bond portfolio includes 100% bond funds. From this chart, we observe that when investors include bond funds in their portfolio, the portfolio is much less volatile than an equity only portfolio. Thus, for an aggressive investor, investing in bonds is an effective way to diversify risk.
Conclusion
If you compare portfolios that comprise bond and equity funds, you will find that the former is always less volatile. The fundamental reason behind this is that bond investors are effectively debt holders of the company and have a claim to the assets of the company when the company goes bankrupt. Equity-holders do not have this advantage. This actually means that investors take on less risk when they invest in bonds. In addition, the volatility of bond prices will decrease when the bond is closer to maturity. As bonds mature, the debt holder will get back the full amount of the principal. This is unlike equities when prices are volatile there is actually no guaranteed amount that an investor can get back.
During strong market rallies, investors usually go into equities and forget about the importance of diversifying during a period of market downturn. During a market downturn, some investors start to regret not diversifying earlier. Thus, the advice that we would like to give to investors is to make use of the stability of bonds to diversify their portfolio. That would actually mean including bonds or bond funds in an equity portfolio, even if markets are rallying.
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