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How bonds fit into an overall investment portfolio

{6 minutes to read}

This is the second in a two-part series about bonds. The first article, "What You Don't Know About Bonds Can Hurt You" discussed a variety of bond fundamentals that all investors should know. This article will discuss how bonds fit into an overall investment portfolio.

Why should bonds be part of your portfolio?

If you want current income and/or if you want to reduce the risk of owning stocks, bonds are a great diversifier. Their performance characteristics are often "non-correlated" to stocks. When stocks go up in value, bonds may go down or not go up as much.

As an example:

  • In 2008, the Barclays U.S. Aggregate Bond Index (a basket of U.S. investment-grade corporate and government bonds) was up 5% while the S&P 500 (a basket of 500 large company U.S. stocks) was down 37%.
  • In 2013, the Barclays U.S. Aggregate Bond Index was down 2%, while the S&P 500 was up 32%.

Bonds provide dependable current income. This is important if you need current income or want to reinvest earnings. Right now, interest rates are very low, but so is inflation.

When bonds are part of a portfolio, the result is more stable returns than if the portfolio were 100% in stocks. While adding bonds to the mix will limit upside potential during rising stock markets, it helps cushion losses when stocks decline. Most investors don't like the stock market roller coaster and prefer a smoother overall return experience.

The majority of investors believe that interest rates and inflation will probably increase over the next few years. When this happens, won't bonds go down in value and won't this negatively affect your investment portfolio?

Longer versus shorter duration bonds

Successfully and consistently betting on the direction of interest rates is very difficult. Remember that bonds of longer duration are more negatively impacted by rising interest rates than shorter-duration bonds or cash. It may seem prudent to move to cash or short-duration bonds when interest rates are likely to rise, but this strategy may reduce expected returns.

Longer duration bonds typically pay higher interest than shorter duration bonds and cash. If the bonds are held to maturity over a longer term, investors will typically have greater yields and total returns even if interest rates spike or gradually rise.

As a whole, a globally diversified portfolio of bonds with different yields, maturities, durations, creditworthiness, call provisions, etc. may reduce short term interest rate risk. Not all bonds act the same when interest rates change or when there is financial duress.

As an example:

  • The 10-Year U.S. Treasury Bond Yield increased from 2.25% in 2008 to 3.85% in 2009.
  • While the 10-Year U.S. Treasury Bond dropped in value 10% in 2009, High-Yield Bonds increased in value 54% and Investment-Grade Corporate Bonds increased in value 18%.

Should investors own individual bonds, mutual funds or index funds?

There isn't a right or wrong way to get exposure to bonds. Smaller investors will be limited to owning mutual funds or exchange traded funds. The problem with owning funds is that you don't own the underlying bonds. If the fund experiences lots of redemptions, the bond manager may be forced to sell bonds at a loss. While index funds are inexpensive, the index fund you choose may not have the characteristics that are best for you at this time, considering the risk of rising interest rates.

For example, compared to the average actively managed intermediate term bond fund, the Bar-clays U.S. Aggregate Index has a longer duration and a lower yield to maturity. Also, this index is about 45% invested in government securities, which are more sensitive to rising interest rates than other kinds of bonds.

If you are buying or selling bonds from a broker, buyer beware!

While there may be a small transaction fee, the broker will markup the price of the bond with a "commission". If you are hiring an investment firm to actively manage your bonds or to help you build a "bond ladder" (bonds with different maturities), the manager will "negotiate" with buyers and sellers of bonds to get competitive pricing. They don't charge a "commission" because they are typically paid a management fee. Consider a portfolio of individual bonds when the bond allocation is greater than $250,000.

Bonds are an integral part your investment portfolio. It is easy to discount or ignore them while the U.S. stock market has been mostly positive for the last seven years. Even though some bonds may be affected by short-term interest rate changes, a well-managed, globally diversified allocation to bonds can help you meet your long-term accumulation and income goals.

Please call the Raskin Planning Group at 617-728-7433 with questions. Peter Raskin is a registered representative of Lincoln Financial Advisors Corp. Securities offered through Lincoln Financial Advisors Corp., a broker-dealer (SIPC). Investment advisory services offered through Sagemark Consulting, a division of Lincoln Financial Advisors Corp., a registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. 125 Summer Street, Suite 1400, Boston, MA 02110 617.728.7444 Raskin Planning Group is not an affiliate of Lincoln Financial Advisors.

Trading bonds may not be suitable for all investors. Although bonds are often thought to be conservative investments, there are numerous s risk s involved i n bond trading. If you are uncomfortable with any of the risks involved, you should not trade bonds. There is a credit risk involved with trading bonds. When you purchase a corporate bond, you are lending money to a company. There is always the risk that the issuer will go bankrupt. If this happens, you will not receive your investment back. This is a risk of which you must be aware. Credit risk is figured into the pricing of bonds. There is a prepayment risk involved. Prepayment risk involves the scenario where an issuer “calls” a bond. If this happens, your investment will be paid back early. Certain bonds are callable and others are not, and this information is detailed in the prospectus. If a bond is callable, the prospectus will detail a “yield-to-call” figure. Corporations may call their bonds when interest rates fall below current bond rates. A “put” provision allows a bondholder to redeem a bond at par value before it matures. Investors may do this when interest rates are rising and they can get higher rates elsewhere. The issuer will assign specific dates to take advantage of a put provision. Prepayment risk is figured into the pricing of bonds. There is a significant inflation risk when trading bonds. Inflation risk is the risk that the rate of the yield to call or maturity of the bond will not provide a positive return over the rate of inflation for the period of the investment. In other words, if the rate of inflation for the period of an investment is six percent and the yield to maturity of a bond is four percent, you will receive more money in interest and principal than you invested, but the value of that money returned is actually less than what was originally invested in the bond. As the inflation rate rises, so do interest rates. Although the yield on the bond increases, the price of the actual bond decreases. This is a risk of which you must be aware. There is an interest rate risk associated with bonds. Changes in interest rates during the term of any bond may affect the market value of the bond prior to call or the maturity date.

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