Why Are Bonds Still a Great Hedge?
With the coronavirus outbreak, there has been an incredible amount of volatility in financial markets. Most stocks are still trying to recover as the epidemic is making a stronger mark on the world. Investors are worried about the extreme negative trends in their portfolios, yet nothing can be done to prevent this situation. Dealing with such unexpected adversaries can be challenging. However, if you make mindful investments and keep pace with the prevailing trends, most risks can be avoided.
Bonds are one such risk-free tool that helps you guard your investments against possible market risks.
What are bonds?
Bonds, also known as treasury bonds, are securities that are predominantly issued and backed by the US government. Bonds act as an excellent hedge against the rising market volatility since they are fixed return securities that work on a pre-determined rate of interest. The US government issues treasury bonds every quarter and keeps regulating the interest rates as per market conditions. Three main factors determine the price of bonds:
The price quoted by the investors through an auction
The prevailing market conditions
The cost of other competing bonds in the market
The final price of bonds is ascertained after considering all the factors mentioned above.
What makes bonds a great hedge?
Bonds have existed in the market for a long time. When the government seeks a loan or wishes to borrow money from citizens (investors), it issues securities in the form of bonds and certificates. Bonds are a more secure investment avenue as compared to other higher return generating instruments. Here are some notable reasons why bonds can be a go-to option for investors to guard their investment portfolio:
1. Bonds carry a lower risk as they are regulated by the government
The reason why people prefer investing in treasury bonds is that the government backs them. The investment risk in bonds is also nearly negligible as the majority of the investments made by bonds are in G-Secs. However, as a side effect, they offer a lower rate of return as compared to stocks and equities. Bonds aptly fit under the frame of ‘low risk and low return’ instruments. As bonds are considered to be risk-free investments, their returns may not always be so attractive. But this helps investors stay put in all market conditions if they have made balanced investments along the due course.
Investors also need to consider the time-value when investing in bonds. Though bonds are risk free investments, there lies an inherent risk of being subdued by the rising market. When buying a bond, the general idea of every investor is to ensure wealth preservation and make sure that the investment is not a stagnant one. Investors expect decently moderate returns over their investments. When the markets are on an up-rise, other competing avenues generally outshine the treasury bonds failing the initial cost of investment and claiming away any profit that investors may have made.
2. Bonds act as insurance to an investment portfolio
Another huge advantage that bonds carry is that they insure investment portfolios against potential market risk. As a commonly accepted ratio, people invest nearly 60% of their money in stocks and equities and the remaining 40% in bonds and commodities. When the market is volatile, the 40% investment plays a major role in helping investors keep up with the turmoil.
Investing in bonds can offer assured returns to investors at a predetermined interest rate, irrespective of the prevailing market conditions. This function is quite similar to how insurance works. The ultimate goal of investing in bonds is to attain stability over the market crisis and get assured returns.
3. Bonds are the least affected investment tools in cyclic market rotations
All investors know that financial markets work in cyclic movements. A bull market is followed by a bear market, which is then followed by a bull market again. The pattern remains the same. Although the duration of these market cycles cannot be predicted, one can be sure of how they impact investments. But in the case of bonds, market cycles are not very effective. Since there is a pre-determined return on investment in bonds, the market volatility is of minimal effect.
4. The long-term upholding of bonds outshines market volatility
While investing in bonds, a lot of investors have come to acknowledge the fact that bonds outshine market volatility when held over a substantial period. Past trends of capital appreciation are a testimony to how bonds remain unaffected by market fluctuations. As per a report released by the BlackRock investment institute, there is a registered 95% success rate of bonds over other similar stock investments. The report also shows that bonds offer 4% better returns than stocks.
5. Bonds are cost-effective
Of all the aspects, one primary concern that investors have while dealing with investments is the effective cost they have to pay. Bonds are an overall cost-effective investment avenue. This makes them an attractive tool for investors. Since bonds can be bought at a lower price depending upon the auction rates, the initial cost that investors pay is comparatively lower than stocks and equities. In addition to this, if investors find themselves at an interest rate risk, they can choose to sell off these bonds to balance out any negative returns.
To sum it up
Bonds are an effective way of hedging your portfolio against any potential loss. Since the return percentage is predetermined on bonds, there is only minimal risk associated with them. This provides high stability to the portfolio and offers insurance against any kind of market volatility. Bonds ensure protection against the inherent market risk in the case of stocks and equities. Therefore, it can be advantageous for investors to invest in bonds and other secured investment avenues to guard their portfolio against probable losses.
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Credit: wiseradvisor.com, treasury.gov, NYSE
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