They are normally the forgotten part of your portfolio. They provide steady returns with low volatility. They aren’t as exciting as stocks, but lately they are on everyone’s minds. I’m talking of course about bonds. Bonds have historically offered lower long-term returns than stocks but provided protection against stock market declines and have been an integral part of any portfolio. However over the past 30 years interest rates have fallen to near zero and seem to have nowhere to go but up in the future. So what does that mean for bonds in your portfolio?
Let’s step back a minute to provide a quick summary of how bonds work. When you buy a bond, you are buying a stream of future payments at a certain interest rate. When market interest rates fall, that bond becomes more valuable because nobody else can buy a bond at that rate anymore. When interest rates rise, the bond loses value because now investors can buy a different bond with a higher rate. Rates have been steadily falling for a long time now and as a result, bond investors have not only been earning interest on their bonds, but also gains on the increase in the bonds’ value.
If you hold individual bonds, you can always hold the bond to maturity, collect the interest payments and receive the principal of the bond at maturity, assuming the entity who issues the bond doesn’t default (default risk). Many of our clients use mutual funds to invest in bonds because it is too expensive to buy individual bonds and you need to invest a large amount of money to diversify the bond portfolio enough to reduce the default risk. Bond fund managers don’t just hold bonds to maturity – they actively buy and sell bonds and therefore generate capital gains when bond rates decrease and will generate losses if rates rise.
We know bonds will lose value when rates rise and we know rates are near zero so should we sell all our bond holdings now before rates rise? Of course not! Here is a list of some reasons why you need to keep bonds in your portfolio:
- We don’t know when rates will rise. The Fed has said it expects to keep short-term rates low through mid-2015, but it’s anyone’s guess if they will stick to this and if they do, we don’t know how intermediate and long-term rates will react.
- If you keep expectations in check, bonds will still do their job and provide ongoing income and stability to your portfolio. Don’t expect your bond portfolio to earn 6-8% annual returns like we’ve seen recently. If you expect more modest returns and keep a long-term focus, you won’t be disappointed.
- In the long run, higher rates will actually benefit bond investors, assuming inflation stays in check. While the value of your bonds will face a short-term decline in value, new bonds will be issued at higher interest rates. If you are invested in a bond fund or have a bond ladder, money from maturing bonds can be reinvested in bonds with higher yields that will eventually help you recover the short-term loss in value.
- Keeping your duration short and your bond portfolio diversified will help protect against a spike in interest rates. Long-term bonds will face a steeper drop in value when rates rise so try to stick to shorter-term bonds, even though that means lower rates right now. Make sure you have some exposure to other bond categories like TIPs, international, high yield and emerging markets. They will behave differently than high quality corporate and municipal bonds and provide some diversification to your portfolio. Just be aware that some of these bond categories are much more volatile.
- Remember that even when rates rise and values decline, we aren’t likely to see bonds fall 30-40% in value in a short period of time like we saw in the stock market in 2008. A 5-10% loss on your bond portfolio might feel just as bad though, especially when it’s been so long since we’ve seen bonds lose value at all. But keep things in perspective – a short-term loss can result in long-term gain.
- Bonds are still the best complement to stocks in a portfolio. They have a low historical correlation to stocks so if stocks take another plunge, bonds will help soften that blow. Just look back to 2008 when high quality corporate and government bonds provided positive returns while stocks were in a free fall. We don’t know when stocks might see another 2008 so having that protection from bonds is critical.
- DIVERSIFICATION! We say this over and over again but we really can’t stress it enough. Bonds continue to be the best way to add diversification and reduce volatility in your portfolio.
Remember it’s important to come up with an asset allocation that makes sense for you given your risk tolerance and return objectives, then sticking to this allocation for the long term. We can’t predict what the markets will do in the short-term so having a long-term plan for your money is the best way to accomplish your goals. Now is a great time to review your asset allocation and your bond portfolio to make sure they are in line with your goals.