173. Do You Actually Need Bonds In Your Investment Portfolio?

The Stocks and Savings Podcast

The episode explores the fundamental role of bonds in an investment portfolio and whether they are necessary for all investors. The hosts ex

Key takeaways

• Bonds function as loans to entities like the UK government (gilts) or corporations like Apple in exchange for interest payments.
• There is an inverse relationship between interest rates and bond prices; rising rates typically cause existing bond values to fall.

Main topics

• Bond mechanics and types
• Interest rate impact on bond pricing

Notable quotes

Essentially, when you buy a bond, you are just lending someone money.

Conclusion

Bond allocation should be personalized based on how much volatility an

Transcript preview

Speaker 1 (0:00) If you've done some research into investing and building a portfolio, you'll have undoubtedly read about a specific type of investment, bonds. And it got us thinking. Talk a lot about our global stock ETFs, individual companies, the benefit of compound growth over long periods of time, but we've never actually spoken about bonds in much detail, in part because they aren't included in our personal portfolios. Speaker 2 (0:25) But there's a reason that bonds are in millions of investment portfolios here in the UK. So today we want to try and answer a pretty simple question. Do you actually need bonds in your investment portfolio? We'll explain what they are, how you can invest in them, why investors use them, why we don't use them at the minute, and most importantly, how the answer changes from person to person. All on this episode of the Stocks and Savings Podcast. Speaker 1 (0:51) Hi, we're Andrea and Jamie, two millennial investors and qualified accountants that are here to help you become more confident about the world of investing and finance. We want to give a disclaimer that we are not financial advisors. Nothing in this podcast should be treated as financial advice. This is for educational purposes only. When investing, your capital is at risk and the value of your investments may rise and fall. Past performance does not guarantee future results. Speaker 2 (1:13) We'd like to thank our sponsor Trading 212 for helping us to bring you this episode. Trading 212 is an investing platform which aims to democratize investing. It's also the platform that we trust with our stocks and shares ISAs, but more on that a little bit later on. So I guess before we get on to whether or not bonds should be a part of your investment portfolios, we should actually start by explaining what bonds are. Because honestly, we both learned about them at university and... For me, at least, it took me a while to wrap my head around them. But once I did, I realized that understanding bonds is actually very simple. Essentially, when you buy a bond, you are just lending someone money. So if you buy a £100 bond, you are loaning that person or organization your £100. And in return, they will pay you interest each year for the duration of the bond. And then they'll give you your original £100 back once it reaches its maturity date. The risk here tends to be lower than with stocks, but obviously there is a risk that you don't get repaid. And that risk increases or decreases depending on who you're lending to. For Speaker 1 (2:22) example, you might be lending to the UK government by purchasing UK government bonds, known as gilts. Or perhaps the US government, where their bonds are known as treasuries. Or you might be lending to a company like Apple or Tesco by purchasing their corporate bonds. Those government bonds issued by developed countries are generally considered lower risk. It's unlikely that the UK or US government defaults on their debts. Corporate bonds, meanwhile, can pay a bit more interest because there's a greater chance that the company could run into trouble and fail to repay you. But even then, the levels of risk are different. Apple is far less likely to go bankrupt than, say, Boohoo.com. So you'd receive much more interest from a Boohoo.com corporate bond to try and make up for that increased risk. Speaker 2 (3:12) Anyway, at their core, that's what bonds are. Simply a loan from you to some government or business. They pay you interest each year and then repay the original amount once the bond reaches its maturity date. Speaker 1 (3:25) That said, most of us aren't necessarily going to be sat there seeking out the best individual government bonds to buy. In the same way we think an ETF is the easiest way for people to invest in thousands of stocks around the world, you can also invest in bonds through a bond ETF. Speaker 2 (3:41) One example is the Vanguard Global Aggregate Bond ETF, ticker VAGS, which owns around 12,000 investment-grade bonds from governments and companies all around the world. Rather than lending one company a thousand pound and hoping they pay you back, your money is spread across thousands of different loans to thousands of different companies and governments. And this is actually the ETF I use in my mum's self-invested personal pension. Speaker 1 (4:09) There is one important difference between buying an individual bond and buying a bond ETF though. If you buy an individual bond and hold it until maturity, assuming the organisation you loan to doesn't default, There is a point where that particular loan ends and you get your original amount back. That is, by the way, what maturity means. That it ends and you get your money back. A broad bond ETF doesn't have one maturity date. It constantly owns bonds that mature and then replaces them with new ones. So instead, the value of the ETF moves around, up and potentially down. Speaker 2 (4:47) Which brings us on to another important point. Bonds might be lower risk than stocks, but they are not equivalent to cash. For example, if interest rates rise, then existing bonds normally fall in value. And so would your bond ETF. To understand how this works, let's go back to thinking about how single bonds work. Imagine you own a UK government bond that pays 3 % interest each year. All of a sudden, interest rates have risen and there are brand new UK government bonds available that will pay you 5 % in interest each year. If someone has £100 to spend, they're going to buy the newly issued bonds paying 5%, not your 3 % bond. Unless they can buy your 3 % bond at a lower price. So that's why higher interest rates make bond prices full and vice versa. lower interest rates can make bond prices rise. So that's one thing to know about what can cause bond ETFs and bond prices to move around over time. Speaker 1 (5:48) One thing we'd look for with a global bond fund is whether the currency is hedged back to pounds. And hedging basically means the fund is doing some clever things in the background to stop currency fluctuations having as big an impact on the fund. Vanguard's latest research uses a pretty simple rule of thumb. Generally, don't worry about hedging foreign shares, but hedge foreign bonds. That's because the entire reason you own bonds is to make your portfolio more stable. You probably don't want fluctuations in the dollar, euro or yen suddenly creating a load of extra volatility. Speaker 2 (6:24) Okay, so now that we've gone through what bonds actually are and a couple of key points about them, it's on to the interesting question. If shares have historically delivered higher long-term returns, why would you deliberately put some of your investments into bonds if they're expected to grow more slowly? The main answer is risk management. Vanguard looked at more than 20 years of data ending in 2025 and found that hedged global bonds had volatility of roughly 3 % per year compared to over 17 % for global equities. And equities just basically just means stocks. And the largest drawdown, so by drawdown