Education

Bonds 101: Leveraging Bonds for Portfolio Diversification

What you will learn

Potential benefits of bonds
The role of bonds within a broader investment portfolio

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.

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.

Annual Returns by Asset Class: 1991 - 2023

A bar chart shows the historical volatility of five different asset classes – including bonds and stocks – over recent decades. The bars are shaded in blue above the horizon (zero line) for gains, and shaded in green below the line to reflect losses. On the far left is a bar representing U.S. equities, which ranges from 32% for the highest annual return, and roughly negative 36% for the lowest, with a historical average of positive 10%. Next, to the right, is a bar showing global equities, whose highest annual return is about 40%, with a lowest annual return of negative 40%, and an average of around 8%. (Global equities shows the widest return range on the chart.) Next, U.S. bonds, by contrast, have a highest annual return of about 18%, and a lowest annual return of about negative 2%, with an average of 5%. Similarly, global bonds ranges from 20% to negative 4%, with an average of about 5%. Furthest to the right, cash shows only a highest annual return of about 5%, with an average of about 2.5%.

Source: Bloomberg as of 31 December 2023

U.S. equities are represented by the S&P 500 Index, global equities are represented by the MSCI EAFE Net Total Return Index, U.S. bonds are represented by the Bloomberg US Aggregate Bond Index, global bonds are represented by the Bloomberg Global-Aggregate Total Return Index and cash is represented by the FTSE three-month Treasury Bill Index. Past performance is not a guarantee of future results. Performance reflects unmanaged index returns and is not representative of past, or predictive of future performance of any PIMCO strategy or investment product. It is not possible to invest directly in an unmanaged index.

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