Government bonds issued by developed economies (hereinafter referred to as “government bonds”) play a prominent role in well-structured fixed income portfolios, reflecting the attractive investment characteristics of full-faith credit obligations of the government and the liquidity of debt securities issued by the government. Because government bonds enjoy the full-faith and credit backing of the corresponding government, bond investors face no risk of default. Holders of government bonds sleep secure in the knowledge that coupons and principal payments will be made in full and in a timely manner.
Note 1: Corporate bonds are intentionally excluded in the discussion due to their undesirable characteristics.
Note 2: Government bonds issued by emerging economies carry material default risk, as opposed to those issued by developed economies. This is evidenced by the 1982 Mexico default, 1998 Russia default and 2002 Argentina default, among others.
Interest Rate Risk
Lack of default risk does not liberate bond holders from price fluctuations. When interest rates rise, bond prices fall, as holders of existing bonds need to price-in the now-higher rates available on newly isued debt. When interest rates fall, bond prices rise, as holders of existing bonds require greater compensation for their now-more-attractive fixed stream of relatively higher future payments.
Duration measures the effective maturity of a bond, considering the timing and present value of individual cash flows received over the term of the bond. Longer duration bonds exhibit greater sensitivity to interest rate fluctuations than shorter duration bonds. By increasing a bond portfolio’s duration, investors gain greater exposure to interest rate fluctuations.
Source: Investopedia – The Basics of Bond Duration
Fixed Income Characteristics
Fixed income exhibits a number of compelling characteristics.
Diversifying Power – Government bonds provide good diversification for investment portfolios, protecting against financial crisis and economic distress.
In the stock market collapse of October 1987, when U.S. equity markets plunged more than 20% in a single day, investors sought the safe haven of U.S. Treasuries. Even as equity prices fell off a cliff, government bonds staged an impressive rally.
During the 1998 Asian Financial Crisis, investors engaged in a “flight to quality”, favoring U.S. Treasuries. Similarly, amid the 2008 Great Recession, government bonds provide the greatest degree of protection to investment portfolios.
Bond Prices & Inflation – Investors in traditional government bonds receive nominal returns. However, investors that seek to maintain the purchasing power of portfolio assets need to keep pace with inflation. For holders of traditional government bonds, changes in inflation influence real returns in unpredictable ways.
Unanticipated inflation is negative for fixed income, but positive in the long-run for equity. Unanticipated deflation is positive for fixed income, but negative for equity. Fixed income therefore provide the greatest diversification relative to equity in cases where actual inflation differs dramatically from expected levels.
Alignment of Interest – Interest of government bond investors and the corresponding government are better aligned than the interest of corporate bond investors and corporate issuers. The government sees little reason to disfavor bond holders, as this affects the government’s credibility and its future access to credit markets.
The purity of non-callable, long-term, default-free government bonds provides the most powerful diversification to investment portfolios, serving as a hedge against financial distress and unanticipated deflation. But the porfolio protection provided by government bonds comes at a high price. Expected returns for fixed income fall short of expected returns for equity. The ironclad security of government bonds causes investors to expect and receive low returns relative to those expected from risker assets like equity. Astute investors therefore make modest allocation to government bonds for its modest expected returns and adverse reaction to inflation.