Determining The Advanced Investment Strategies Which Use Bonds To Offset Stock Market Investment Risk
Thursday, July 3rd, 2008 Subscribe To Our Feed
Investment strategy is all about risk and reward. This equation is never more important than in times of high market volatility. In the past, bond investment been seen as a fairly unexciting investment, but as part of a balanced portfolio, bonds have an important role to play. Today we discuss the advanced investment strategies which use bonds to offset stock market investment risk.
Firstly, bear in mind that returns can be significantly improved by judiciously investing in corporate bonds. What are corporate bonds? They are the money raised by corporations over and above the sales, services, loans from banks and stocks. In essence, you, the investor, are lending money to the corporation issuing the bond. Unfortunately, not too many investors have taken the time and the effort to understand this instrument.
Bonds are usually with companies for 10 years, after which they reach their maturity date. The capital is returned.
While they are relatively safe, bonds too have certain risk factors such as Credit Risk, Interest Risk and Maturity Risk.
Managing credit risk – the risk of default. There are, happily, credit rating agencies which rate the credit risk of a company. Poor’s and Moody’s and Standard are two such agencies.
Managing interest risk – market rates may move against you while you are on a fixed interest rate. On the other hand, they may move in your favor!
Maturity risk – some bonds are “callable”, which means the issuer can redeem them early. This means that if you have been used to getting a high rate of interest, this might unexpectedly stop if the company redeems the bond early.
Let’s now look at the advantages of corporate bonds. If you are cautious and invest in high yield bonds that are healthy and not junk bonds, you can stand to gain a lot. You also have convertible bonds where you can buy bonds that convert into stock directly from the company rather than from the market. This means you can take advantage of the company’s price appreciation while enjoying the safety factor of a bond. The price of the bond usually does not fall below a decent price return.
Because bond values are driven by different factors from stock and property values, bonds can provide a buffer against volatility in your investment portfolio. Studies have shown that holding between 20% and 40% of a stock portfolio in bonds can reduce the extent of negative movements (losses) across the overall portfolio, without a commensurate reduction in the average gain across the overall portfolio. That is, there is some loss of profits when things are going well, but that loss is smaller than the reduction in losses when things go bad.
If you buy bonds at issue and hold them until their maturity date, you have a relatively lower risk investment than if you try to get fancy. You must thoroughly understand the risks and rewards of investing in bonds by buying when they are issued and holding them until maturity before starting to trade in bonds. You can get significant benefit from holding bonds, however, as their value movements tend to offset large downward movements in the stock market. Corporate bonds pay significantly higher coupon rates, and some may even be convertible at attractive terms. The wise investor will always include bond investment in their investment strategy.
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