Why do Investors Hold Fixed Income Securities?
The bond market is much larger in size as compared to the equity markets of the world. This is because a large portion of the bonds sold in the market is sovereign debt. For more than two centuries, various countries have been routinely turning to the bond market in order to borrow money. With the passage of time, corporations and other financial institutions also started tapping this market. However, the question is why do investors hold fixed income securities? The answer is subjective. Different kinds of investors buy fixed-income securities for different reasons. In this article, we will have a closer look at some of the common reasons behind the investment in fixed income securities.
Capital Preservation: There is a large segment of investors for whom the security of their capital is more important than the return on investment. A perfect example would be an investor who is old and wants to preserve his/her wealth. For such investors, equity markets are not really an option since they are so volatile. Hence, fixed income securities are the next logical choice. These investors may have liabilities that they have to pay by a certain date and hence cannot afford too much fluctuation in the value of their capital. The maximum allocation of fixed income securities is typically seen in the portfolio of risk-averse investors.
Regular Income: One of the biggest reasons people hold bonds is because they provide regular income to the investor. Firstly, it is important to note that since bonds are long-term in nature, the yields on these bonds are typically a few basis points higher as compared to the prevailing interest rate in the market. Secondly, bonds do provide money at a pre-determined frequency to the investor.
In most cases, the nominal amount of money being paid out does not change. This money can be used by the investor either to make another investment in the bond market or they could also spend this money for their day-to-day expenses. It is true that stocks also provide regular income in the form of dividends. However, this income is usually less as compared to bond coupons and also there is no obligation to the company to issue a dividend. Hence, dividends cannot be counted on for being a regular source of income.
Capital Appreciation: The bond market has seen a great deal of volatility since the 1970s and the 1980s. This is because the price of bonds is inversely related to the interest rates in the market. Interest rates have been very volatile in the past few years causing the same volatility to spill over to the bond market as well. As a result, there are many investors who invest specifically to take advantage of the change in prices.
The prices of bonds change over the life of the bond. However, if the bond is held to maturity, the earnings become equal to the stated coupon rates. However, if investors are able to sell their bonds when the price appreciates, they are able to earn a higher return. This type of investing wherein the investor tries to make a gain from coupon payments as well as capital appreciation is called total returns investing. This approach has become quite popular in the past few years.
Diversification: A lot of investors hold bonds just to diversify their portfolios. This is because a lot of assets such as equities and commodities tend to behave in the opposite manner as compared to bonds. This means that when the price of bonds increases, it is likely that the price of equities will go down. This negative correlation is used by many investors to average out their returns when it comes to bond investing. Almost all portfolio managers suggest their clients have a well-diversified portfolio. This is the reason that bonds are a part of almost every portfolio.
Hedge Against Slowdown: There are some investors who hold bonds simply as a hedge against slowdowns in the economy. The empirical data and evidence paint a clear picture. Historically, bonds have performed well in periods of recession. This is because of several reasons.
Firstly, during the slowdown, companies are earning very little interest and some are even going bankrupt. Hence, there is a flight towards safety which ultimately leads to a rally in the bond market.
Also, if the dividends provided by companies reduce, then the coupon payments of the bond start to look very attractive to certain investors. This also causes the prices of bonds to increase.
Lastly, it must be understood that the nominal coupon payment paid by the bond remains the same irrespective of external market conditions. Hence, in the event of deflation, when the prices of goods and services are reducing, the same nominal payment becomes even more valuable. This also incentivizes investors to have bonds in their portfolios.
Investors cannot begin buying bonds during a recession since by then the prices would have already risen. Instead, they must always hold a certain amount of bonds to take advantage of the situation as and when slowdowns occur.
The fact of the matter is that there are many different kinds of investors in the bond market and they each have their own motivations. The differences of opinions and motivations are what ensure liquidity in the bond market.
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