How To Properly Manage Bonds In Your Investment Portfolio

Over the years, as I have spoken to quite a few people about bonds, the various conversations have often taken a different direction, depending on the “environment” at the time.  Take, for example, 1999, when common stocks were on a tear; then I had to explain the reasons why anyone would want to invest anything at all in the bond market.  And in recent times, in this “environment” I’ve actually had to talk investors out of investing too much of their money in bonds. 

These are both examples of what Behavioral Economists call “recency.”   Meaning that we tend to place more emphasis (and trust, appropriately or not) on more recent data even as we ignore older data. 

A more general problem, I’ve found, is that investors don’t understand the role that bonds should play in an investment portfolio.  When you buy a bond you are essentially lending money to some entity, whether it’s a corporation, a municipality, a state, or a country.  In exchange for what is essentially your loan, you are promised a regular payment, usually on a semi-annual basis, plus the full amount of the money you lent returned to you at a given date.  Depending on the circumstances, you may or may not realize the promised returns. 

Bonds are considered “fixed income;” investing in them generally means that you will not gain as a result of growth in the economy.  Bonds are considered safe and therefore have a lower expected return than stocks.  But bonds have two inherent risks, namely interest rate risk and, more importantly, credit risk/default risk.  Interest rate risk means that when interest rates rise, bond prices will fall, given the inverse relationship between them. 

Default risk describes what happens when the entity has gotten into financial trouble and does not return your original investment.  Take for example, Greece; certainly you have heard how the threat of Greece defaulting on their bonds is playing havoc with markets there and across the globe. 

Portfolio strategists view bonds as a way to provide stability to a portfolio.  Accordingly, this approach argues for only buying high quality bonds, i.e. those with the highest credit ratings.  The reason is that you won’t want an economy which is going through a “soft patch” to adversely affect both your stock portfolio and your bond portfolio at the same time.  The whole idea is that bonds should provide a safer haven than stocks, albeit with a lower expected return.

Conclusion

It is my belief that, as part of a sensible portfolio, fixed income investments must be limited to high quality issues.  I also believe that it’s a mistake for investors to overemphasize bonds in a portfolio, simply because they are afraid of a bad economy or bearish stock market.

Over the long term, stocks have always outperforned bonds.  And over time, it is the erosion of purchasing power that is the biggest risk for most people.  Most bonds do not protect you from the ravages of inflation.

In the long-term, you need both equity investments for growth and bond investments for stability.  How you make that allocation decision is the most important determinant of how your portfolio will behave in the future.

To be continued.

About the author

Roger Streit, CFP®

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