Do Bonds Belong in Your Portfolio?
Most people investing today know that the long term return of owning a portfolio of bonds has significantly underperformed a portfolio of stocks over almost any time period. Especially during the 1990's, bonds have become largely overlooked by individual investors due to the astronomical returns of the stock market. While bonds probably don't belong in everybody's portfolio, there are some really good reasons for holding bonds within the context of an investor's overall portfolio. Stacked up against a basket of stocks, an investor with average risk tolerance will probably choose the equity investment. However, within the context of an investor's entire portfolio of assets, bonds can provide much-needed income or provide risk diversification that can improve the overall risk/return profile of a portfolio.
Portfolio theory tells us that asset classes that are not perfectly positively correlated can decrease the risk of a portfolio, as measured by the volatility of returns. Portfolios of assets that lie on the efficient frontier are said to provide the maximum amount of return for a given level of risk. Since most bonds have a low correlation with stocks, their inclusion in a portfolio of assets can help to increase the risk/return tradeoff. The diversification benefit of adding fixed income instruments to a portfolio of stocks outweighs the lower return generated by such a portfolio. In other words, an all stock portfolio would carry a higher expected rate of return, but if 20% of the portfolio is invested in bonds, the expected return of the portfolio is lower but the reduction in risk offsets the lower return to a greater extent, thus making the portfolio more appealing on a risk/return basis.
In addition to the positive diversification benefits mentioned above, bonds can also provide a steady income stream to a portfolio, and thus are valuable financial planning tools. Bonds can be used to fund known expenditures over shorter time frames, 1-3 years, such as college tuition or a downpayment for a home. As we've all seen, the market does not provide the same degree of security in providing for necessary expenditures. While stocks have not seen a true bear market in some time, the threat of a "correction" can suddenly leave investors with 40% less capital than they had planned for. Thus the security and flexibility of bond maturities allow for more appropriate financial planning needs.
Within the context of financial planning, bonds are excellent tools to provide current income while maintaining equity investments seeking real future growth. Thus, a position in short-term bonds can be used as a hedge against inflation whereas fixed dividend payments from equity cannot provide for the eroding affect that inflation can have on fixed income payments over time. Using a combination of short and long term bonds, investors can ladder their portfolio to provide for interest rate diversification as well. The complexities of bond investing far exceed the scope of this paper, but we will examine some properties of bonds that are relevant within a portfolio context.
There are many types of fixed income instruments to invest in. The most popular and liquid types of bonds are government bonds. Investors can purchase bonds that pay fixed coupon payments, such as 10-year or 30-year bonds, or receive floating payments that are adjusted as interest rates rise and fall. Zero coupon bonds are an asset class that produce no periodic interest payments, thus the zero coupon, but fully fund the principal amount on the maturity date. More exotic bonds include IO's (not the moon of Jupiter but interest only) and PO's (prinicipal only). These securities break up a pool of mortgage payments into principal and interest, and repackage them for investors. In this manner, the two payment streams are isolated and two very different fixed-income instruments are created. With all the different constructions and assortment of fixed-income instruments, investors need to be aware how each security behaves during a period of interest rate volatility. To better understand the risks associate with fixed-income investing, see our article entitled Bond Risks.
Clearly, the decision to invest in bonds at all is guided by an investor's financial goals, investment horizon, and risk tolerance. Once bonds are selected for inclusion in a portfolio, the subtle complexities of the instruments come into play. Armed with the knowledge of how bonds behave in differing interest rate environments, investors can be better prepared to construct their fixed income portfolio in an optimal configuration. See our article entitled Price Risk : Duration and Convexity for a more thorough explanation of how a bond's price behave in differing interest rate scenarios.
