Bonds can appear to be a relatively unglamourous investment option, particularly when there’s eye catching news about booming share prices or crypto-currencies. Yet sharp downswings are also common when placing bets on fashionable, sometimes speculative assets. Bonds, on the other hand, are central to strategies of steady accumulation.

“Taking a balanced approach is the way to meet each individual’s needs and desires by bringing resilience and growth together,” said Flavio Carpenzano an investment director with Capital Group. “The person who is considering retirement in five years time will have different investment needs that the young person just starting out,” he explained. “Yet in all cases, bonds can play a role in matching each investor’s personal appetite towards risk and reward,” he added.

A bond is a financial security that is a loan made (normally to companies, states, local authorities etc) to finance projects and operations. The money is lent for a specified, limited time period at which point the capital is repaid, with interest having been paid to the lender on a regular basis. Generally, the riskier the loan (in terms of the issuer defaulting), the higher the interest rate will need to be to encourage the investor to lend.

For example, Luxembourg-based steel giant ArcelorMittal is very active on the bond market, and in recent years has offered interest  However, this situation contrasts with that of the Luxembourg state itself which is able to issue bonds with a negative interest rate, in other words, returning slightly less money to the investor than they originally lent. At the last bond issuance by the Grand Duchy in 2020,  per annum.

How to understand this? ArcelorMittal is relatively highly indebted and operates in a somewhat volatile market. Hence investors may have some concerns that the company might go bust, which would wipe out their investment (in case of being bankrupt, the bond holder may not get his capital back). To entice investors to lend, the company has had to offer an interest rate that pays for the risk taken by the investor, while at the same time that covers for some inflation. This contrasts with the Luxembourgish State: being well-run, with low levels of public borrowing, and a currency and economy backed by the European Central Bank, it is perceived as being of low risk, and hence, it can pays … a negative rate to those buying its bonds.

Despite the negative interest rate, Luxembourg bonds were over-subscribed by investors in 2020 because they are confident that the Grand Duchy will not default on their promises, this is that the Luxembourg State was perceived as a “close to no risk” investment. The obvious question here is “why not just keep cash in the bank?” The answer is that during times of crisis such bonds become highly sought after and they can be sold at a premium. Cash offers no such flexibility to asset managers.

However, at the moment, the world economy is experiencing a high growth, high inflation phase. “This moderates the higher levels of risk of high yield bonds and so they have become more attractive,” notes Mr Carpenzano. But during the early days of the pandemic when the market was fearful, demand was strong for high security, lower interest bonds. Investors taking a broad-based balanced approach are able to enjoy gains in one part of the portfolio to balance losses elsewhere.

Mr Carpenzano identifies four broad motivations for integrating bonds into a portfolio: capital preservation, income generation, inflation protection and diversification. As regards capital preservation, “an allocation of bonds anchors the portfolio, building in resilience and stability,” he said. “Yes there can be the potential for short term losses in a low yield environment, but history shows that over the medium term bonds usually provide positive returns.”

Income generation had been moderated in recent years by the low inflation, low interest rate environment. Yet a diversified investment in bonds may generate a steady source of income for many investors. This is particularly important for the likes of pensioners who are no longer adding income from their salaries to their investment pot.

Bonds offer a hedge against inflation. Cash kept in a safe in your Luxembourg home is now worth more than 5% less than it was a year ago due to the recent sharp increase of inflation. However inflation linked and high yield bonds are currently performing well thanks to the improvement in the global economic environment. Conversely, safer bonds (such as those issued by Luxembourg, Germany and the US treasury) are suffering somewhat.

Again, diversification within bond holding is key. And in themselves, bonds offer diversification away from the shares that you will probably also hold in your portfolio. Shares are an excellent long-term investment, but they do experience volatility and “market corrections”. You need to be prepared.

“Successful investors take a careful strategic approach, tailored to their life situation and objectives,” said Mr Carpenzano. “By helping people to secure their wealth with the opportunity of growth, bonds are an essential part of any investor’s toolkit,” he added.

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