The role bonds can play in an investment portfolio

Just like mechanics need to know how different cogs work in an engine, it’s helpful for investors to understand how different products can work alongside each other in an ISA or pension.

Shares get a lot of attention when people start to explore investing, but what’s often underappreciated is the role that bonds can play in a diversified portfolio. They can work nicely alongside shares as well as on their own.

In a nutshell, bonds act as a source of steady, reliable income in a portfolio, helping reduce volatility and increase diversification from more risky investments like stocks.

Four ways bonds can help you

Predictable income stream. Bonds are a way for companies and governments to borrow money by issuing bonds in exchange for cash.

You buy the bond and receive regular interest payments over a set period, with the issuer paying back the original value of the bond at the end. Interest payments are typically made every six months, helping you to budget and know when money is coming into your account.  

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A smoother ride. A lot of people think investing is like riding a rollercoaster where you go up and down, and from side to side. While stock markets never travel in a straight line, holding bonds can help to dampen the movements in your portfolio. Although bond values can still fall, particularly when interest rates rise, they tend to experience smaller fluctuations than shares.

Offer diversification. Bond and share prices are influenced by different factors. Stock prices can be driven by company profits whereas bond prices are heavily influenced by interest rate expectations and inflation. That means bonds don’t always move in the same direction as shares.

Help preserve capital. Investors want to build wealth, and they also do not want to lose money. Certain types of bonds can act as an anchor within a portfolio, such as high-quality government bonds. Investors who hold these bonds until they mature can typically expect to receive a regular stream of income and the face value of the bonds at the end.

How do you add bonds to a portfolio?

You can buy bonds individually or through a fund. Most retail investors tend to do it via a fund as it is an easy way to get exposure to lots of different bonds and spread your risks.

There are different types of bond funds available. You can get an active fund where a manager makes all the decisions about what is held in the portfolio. Alternatively, you can buy ETFs or tracker funds which mirror the performance of a specific basket of bonds, and the charges are typically lower.

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You can choose to invest in funds that only invest in bonds issued by companies, known as corporate bonds. There are funds that invest specifically in government bonds. Or you can buy a strategic bond which has a mixture of the two.

Another way to get exposure to bonds is via multi-asset funds which contain a mixture of shares, bonds, and sometimes other assets such as property or gold.

How much should I have in bonds?

There isn’t a one-size-fits-all answer to this question. It all depends on your risk appetite, investment time horizon, and other investments you hold.

Historically, many people followed a rule that said to deduct your age from 100 to calculate the proportion of your investments to hold in shares and the rest held in bonds. This is now considered to be outdated, particularly as more people are living for longer and want to keep growing their portfolio in retirement.

We’re now seeing more people keep a higher weighting to shares in the early part of retirement as they look to achieve both income and growth.

Shares have historically delivered higher returns than bonds, which is why they typically form the foundation of pre-retirement portfolios. For younger and middle-aged investors, the focus is usually on long-term capital growth rather than generating income, making the stability and income offered by bonds less of a priority.

Multi-asset funds typically come in different shapes and sizes, where you select a fund based on your risk appetite. More cautious-style multi-asset funds would have a higher weighting to bonds compared to adventurous style versions.

Hypothetical examples

Let’s run through a few scenarios. Adam is in his mid-30s and chooses a multi-asset fund split by 80% equities and 20% bonds. He accepts that bonds may produce a lower return than shares, but he is nervous about investing and likes the idea of having something that might help to smooth out the ups and downs of his portfolio. The bonds inside the multi-asset fund provide an income stream which Adam plans to reinvest so he can enjoy the benefits of compounding.

Adam’s mum, Sally, is aged 60 and plans to retire in the next two years. She wants to lower the risks in her portfolio and make it ‘retirement ready’ which might include increasing exposure to bonds and income-generating shares. She sells one of her global equity funds and uses the proceeds to buy a strategic bond fund which invests in bonds issued by companies and governments from different parts of the world. Sally still has other funds with exposure to stocks and shares, and she intends to gradually reduce these holdings and buy more bonds as she grows older.