In a low-interest rate environment, it’s normal to ask the question, “Why would I own bonds in my portfolio?” Or, as some have rhythmically remarked, “Why be a loaner when I can be an owner?” Here are some things to consider:
Individual bonds can give principal protection with a steady stream of income. If you loan a corporation, government, or municipality $100,000 of your money, they “promise” to give you the money back after a specific number of years and pay you interest along the way. Granted, interest rates, and therefore the income that follows, are at historic lows, but still a “promise” of principal protection with an income stream is attractive to certain investors. I use air quotes over “promise” because this is all subject to the credit worthiness of the issuer. If the company, municipality, or government fails, you risk partial or total loss. Remember mutual funds or ETFs don’t have principal protection like individual bonds, but they can have the benefit of buying or selling bonds as interest rates change over time.
Bonds are higher on the bankruptcy hierarchy of companies. For example, if AT&T issues a bond, and later goes bankrupt, bondholders are paid back first while stockholders are wiped out first. This is another reason why bonds are considered less risky than stocks.
Bonds can be negatively correlated with stocks. Translation: when stocks plummet, bonds can rise. Therefore, many times a diversified portfolio is recommended so that if the stock portion of your portfolio goes down, the bond portion may rise. Seeing some black is better than seeing all red on a monthly portfolio statement. Generally, the last 20 years this inverse relationship occurs, but to be fair, there can be significant periods of time where this does not occur.1
While stock returns have greatly exceeded bond returns over the last two decades, bonds have done pretty darn well too. Since the summer of 2002 the iShares 20+ year treasury bonds ETF is up over 70%. Nowhere near the 380% increase of the S&P 500, but still a significant return.
The occasional boredom of bonds can be psychologically useful in a portfolio to keep you on the path of your financial plan. It can be annoying to see your stocks going through the roof and see bonds hardly doing much of anything but having spots in your portfolio that are not as volatile and stay steady during big dips in the stock market can keep you from selling everything when equities fall.
The bond elephant in the room is of course the historically low interest rate we are experiencing globally. Since interest rates work like a seesaw with bond prices: when interest rates shoot up, bond prices go down. If interest rates are near bottom, it might be the end of the bull market in bonds. Furthermore, if interest rates go up significantly, bonds don’t feel so “conservative” as bond values can drop dramatically.
This begs the question, when will interest rates go up steadily and significantly again? As always, the answer is, no one knows for sure. This is why diversification matters and developing a portfolio that is tethered to a plan and your risk tolerance matters.
Bonds typically, though not always, can play a part in your investment allocation. Ask yourself and a professional if they should play a part in yours.
1. See Jessica Hamlin’s article “Stocks and Bonds Have Moved in Opposite Directions for Decades. Here’s What Could Change That”. Accessed online: https://www.institutionalinvestor.com/article/b1rpyq8lgqdll2/Stocks-and-Bonds-Have-Moved-in-Opposite-Directions-for-Decades-Here-s-What-Could-Change-That.