Let’s face it, bonds are boring. When is the last time you heard a story of a friend, family member, or co-worker giving a hot US Treasury bond tip? There’s a reason (or several) that your answer is probably never.
At blooom, you could say we tend to take a stock-heavy approach to our long-term strategy for the vast majority of our clients. There are many good reasons for that, as we discuss often. But, just because a heavy amount of stocks has proven over time to give investors the highest chance of achieving their long-term goals, doesn’t mean bonds don’t also have a place for some, especially at a certain point in their journey to retirement.
When stocks are doing well (which is fairly often), we tend to get a lot of questions from our clients about the rationale for including bond investments in their portfolios. Bonds can often be viewed as holding the portfolio back from higher returns. But there are several characteristics of bonds that still make them an essential piece of a well-diversified portfolio for certain investors, despite their relatively boring nature.
Let’s start with what investors tend to focus on the most when it comes to any asset class – returns. Performance is the obvious metric most investors ultimately use to gauge the success of a particular investment strategy. But performance, especially over shorter periods, is largely out of an investor’s control. On the other hand, risk is something all investors have the ability to control to a much greater extent, simply by the make-up of their portfolio. Or in other words, the type of investments they select.
Controlling or mitigating risk is actually a much more important indicator of long-term success than trying to chase a specific return goal year in and year out. This is where bonds come in.
A quick review
Since bonds represent a form of debt from the issuer’s (government or company) side of things, they are treated much differently than shares of stock in the event of financial distress like a bankruptcy proceeding. Bondholders receive preferential treatment over stock holders and are more likely to be paid back their investment when an entity’s assets are liquidated.
This is not to say that a bondholder has no risk of losing their investment, as many bond investments can lose value and many bond issuers can default. However, price volatility of bond investments and relative risk of loss for a bond investor, is generally far less than stock investments. But with less risk, comes less return potential, broadly speaking. There is always a tradeoff.
A more comfortable ride
One of the main reasons an investor would generally consider investing in bonds is to reduce the severity of the ups and downs of their portfolio balance over time. We know that wild swings not only make certain investors extremely anxious, but that the stress of seeing an account balance decline significantly, especially in a short period of time, can lead to some very detrimental investment decisions.
Since most bonds, by nature, do not experience anywhere near the level of volatility that stocks do on a daily basis, including them in a portfolio helps offset the risk an investor is exposed to with their stock holdings. For many investors, the smoother ride of a diversified portfolio that includes bonds will end up helping them sleep much better at night and stick to their long-term strategy, which we know is vital to achieve their goals.
While bonds can help a stock-heavy portfolio grow more steadily and smoothly over time, another purpose of bonds in a portfolio is to help protect, or preserve, a greater portion of the portfolio from downside risk, as an investor nears retirement.
At blooom, for the clients we are recommending any amount of bonds to, we include an amount of bond exposure that is designed to slowly increase over time, as our clients get closer to their intended retirement age. The specific amount of bonds we include for any client will ultimately depend on the amount of time they have and their risk tolerance.
As an investor’s time horizon shrinks, it becomes more and more important to slowly reduce overall risk and isolate more of the portfolio from stock market volatility by bumping up that bond exposure.
Income over growth
It’s safe to say that all investors generally want an element of growth in their portfolio. After all, that’s pretty much the entire point of putting your money at risk in any way, in any market, in the first place. But as an investor nears retirement, their priorities for their retirement account(s) should begin to shift from growth to an income-centric strategy. We tend to believe that any retirement portfolio should still maintain an element of growth via stock exposure even IN retirement, but ultimately a retired person is going to need to start relying on their portfolio for income at some point. In addition to your growth “bucket” in retirement, you will need a substantial income bucket as well.
One of the main characteristics of bonds is that they provide a steady and relatively dependable stream of income via interest payments. Many investors will ultimately end up living off of the income their bond holdings generate, in retirement. So, as retirement starts to peak over the horizon for you, increasing your bond exposure helps prepare your portfolio for that big shift from accumulating and growing your contributions, to distributing income to yourself.
For those investors that are still years or decades away from retiring, but have bonds in their portfolio, the interest payments paid out by their bond funds will just be reinvested automatically. That automatic reinvestment of bond interest should help ease the concern many longer-term investors have with holding bonds – interest rate risk.
When interest rates rise, existing bond prices fall. But when interest payments are being reinvested into a bond fund as prices decline, it allows the investor to buy more shares at the lower share price of the fund, and also mitigate that interest rate risk over time. This is really no different than the concept of dividend reinvestment when it comes to stock funds.
An often overlooked reason to hold bonds in a portfolio is quite simply because they aren’t stocks. Stocks and bonds tend to have an inverse relationship when it comes to price movements. When the stock market experiences a broad sell-off, bond markets often benefit as investors generally are selling off their stocks to buy “safer” assets like bonds.
When stocks fall, long term investors should look at the decline as a buying opportunity, in most cases. But without anything other than stocks in the portfolio, an investor doesn’t have any holdings to sell in order to buy more of their stock funds at the lower prices. This is where having bonds can actually present an investor with the ability to take greater advantage of dips in the stock market over time by rebalancing when opportunity knocks.
The bottom line
In an environment where interest rates are at historic lows and many market forecasters and fortune tellers are predicting some poor performance for bonds in the coming years, it’s important not to lose sight of the many different roles bonds actually play in a diversified portfolio. Remember that the purpose of bonds in a portfolio really has little to do with returns at all. And even in an environment where bonds COULD see periods of historically low real returns going forward (not a prediction from us), that does not take anything away from their very important role in a properly diversified portfolio.
If you have questions about your own mix of stocks and bonds, or want to discuss your recommended strategy and how bonds fit in, feel free to reach out to our team of advisors. We’re always happy to dive deeper!
Investing involves risk. Your investments are subject to loss of principal and are not guaranteed. Investors should consider their ability to continue investing through periods of fluctuating market conditions. Diversification doesn’t guarantee a profit and can still result in losses in declining markets. The information does not represent a recommendation to buy or sell securities.
Published on May 7, 2021