Back to Basics: Bonds
Updated: Aug 1
Bonds have many benefits in your portfolio including diversification, volatility dampening, and a hedge against stock market risk.
Bond values are impacted by a change in interest rates.
Higher interest rates are better for savers and bond holders.
Determining how much of your portfolio to allocate to bonds depends on your time horizon, risk tolerance, and goals.
The last 18 months have been a rollercoaster ride for bonds -- something we haven’t experienced for nearly half a century. Typically, bonds are an area of safety and low volatility, but they were anything but in 2022. So, what happened and where do we go from here?
Why Bonds Are Less Volatile Than Stocks First, let's talk about how bonds work. Bonds pay a fixed coupon. You know how much money you’re going to get at the end of each period (quarter or year). There’s not as much volatility as with stocks, and if the company goes bankrupt, bondholders get paid before stockholders. Much less speculation occurs with bonds than with stocks, real estate, and commodities. There are also tax advantages to holding bonds. Government bonds are not taxed at the state and local level. Municipal bonds are generally tax-free at the city, state level and federal levels although you still must report the income.
Benefits Of Bonds in a Portfolio
Bonds have many benefits in your portfolio including diversification as well as being a volatility dampener and a good hedge against stock market risk. We’re still dealing with the Russia-Ukraine war, a possible recession, and elevated levels of inflation. But with the debt ceiling crisis removed and the current pause of the Fed’s rate hiking cycle, bonds appear much more attractive than they have been over the past decade. How much should be in stock? How much in bonds? How much in liquid cash? That allocation decision comes down to each client’s time horizon, risk tolerance, and goals. These are questions we help each of our clients answer individually. There is no one-size-fits-all solution.
Portfolio #1: 40% Stocks/60% Bonds Portfolio #2: 100% Stocks
As you can see by the two charts above, Portfolio #1 that’s 40% bonds and 60% stock will weather downturns much better than riskier Portfolio #2 which is 100% stocks.
If you are young, with many years of working (i.e., wealth accumulation) ahead of you, then you can take a great deal of risk because you have the longest time to recover. However, if you are nearing retirement, or if you’ve just sold your business or come into an inheritance, you may want to take less risk.
Inflation And Rising Interest Rates: Pros and Cons
The headlines in 2022 were dominated by fast rising and persistent inflation, and by the Federal Reserve’s attempt to combat it. The Fed’s primary tool for quelling inflation is to raise interest rates in hopes of slowing a red-hot economy. The strategy is working to a certain extent, but when the Fed raises interest rates, it causes a ripple effect throughout the bond marketplace.
For instance, if you’ve been holding on to a three-year government bond that you bought several years ago (when rates were historically low), that bond might only be paying a coupon of 1%. Now investors can get that same three-year bond with a 3% coupon. To make your bond more attractive to investors, you have to lower the price of your bond significantly.
Most of the bonds we’re holding for clients are in mutual funds or ETFs. These well-diversified funds hold a wide variety of bonds with different maturities and different levels of risk. Most of the bonds in those funds will be held to maturity. Yes, there’s a little bit of downside for holding those bonds to maturity since they offer a lower coupon than new bonds you could buy today. But as soon as those bonds mature, the fund companies will have a pile of cash that they can use to purchase new bonds with a higher coupon rate reflecting today’s higher interest rate environment. This is great news for savers that have a meaningful amount of their portfolio allocated to bonds.
The Fed has currently paused raising rates. The Federal Reserve Board members are currently indicating it may ease the pace of rate hikes going forward. This again is good for bondholders because you will be earning a higher interest rate over time than you have in many years (4% to 5% today vs. 1% to 2% for most of the past decade).
Bond holders also benefit if interest rates start to drop. So, if you’re holding bonds yielding 4% to 5%, you’re holding an asset with a higher coupon rate than what’s being offered on the market. People will have to pay you more (not less) to purchase your bonds from you. The inverse of what was explained above when rates were rising. This is important to know. Attempting to time the bond market can be as or more detrimental as attempting to time the stock market.
At Novi, we tend to take a very safe approach on the bond side for our clients since we take a little more risk on the equity (stock) side. We’re tilted toward short-term high-quality bonds. This helps reduce the volatility when rates are rising, however it does sacrifice some potential yield when rates are high. We also tend to emphasize high-quality bonds over low-quality bonds. High-quality bonds are relatively lower yielding, but they have a much lower risk of default. The combination of additional risk in stocks and lower risk in bonds can provide better risk versus return outcomes.
Bottom line: Rising rates can be difficult to endure, but the benefits of the higher rates and longer-term volatility dampening provide a more stable experience for people relying on their assets for their lifestyle.
If you or someone close to you has concerns about the fixed income allocation in your portfolio, please don’t hesitate to reach out. We’ve helped many clients like you in similar situations.
RYAN A. DUNN, CFP®, is a Wealth Manager at Novi Wealth
Disclaimer: Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter (article) serves as the receipt of, or as a substitute for, personalized investment advice from Novi Wealth Partners. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.