Bonds have three basic purposes in the portfolio: to diversify a stock portfolio, to maximize total return, or to generate income. Depending on your objective, there are several strategies open to you.
Diversifying a Stock Portfolio
Adding bonds to a stock portfolio is one of the main ways to reduce investment risk. Bonds accomplish this because their performance cycle is generally out of sync with the ups and downs of the stock market. In years when stocks are performing poorly with weak or negative returns, bonds may be outperforming stocks.
In fact, that was the case in six out of the last 13 years. In three of those years, bonds (as represented by the Barclays Aggregate Index) were the top-performing asset class; and in two of the years, bonds achieved returns that exceeded the long-time average of 10% for S&P 500 stocks. Looking into the previous decade, in 1995, bonds returned 18.5% and twice returned more than 9%. Meanwhile, bonds lost money for investors only twice in the last 20 years (-2.9% in 1994 and -0.8% in 1999) four years, with losses ranging from -9.1% to -37.0% (Source: Callan Associates, Inc., 2013). These returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment vehicle. Historical returns are not indicative of future returns.
Professional money managers measure risk by a statistical value called “standard deviation” expressed as a percentage. Over the last 10 years, stocks returned a compound average annual return of 5.4% and were characterized by a standard deviation of 18.3%. Meanwhile, bonds returned an average of 4.0% with a standard deviation of 1.6%. That means that as an asset class, bonds generated nearly 80% of the return of stocks, but with less than one-tenth of the risk.
By adding bonds to an all-stock portfolio over the last 10 years, an investor could have potentially achieved close to the same returns of the stock market with much less risk. Again, using the returns from the tow indexes, a portfolio comprising 60% stocks and 40% bonds would have generated nearly all of the return of an all-stock portfolio – 5.2% versus 5.4% – with 40% less risk (10.9% versus 18.3%).
When your goal is to reduce the risk of your overall investment portfolio, it’s important to buy high-quality bond issues and avoid investing mainly in long maturities. Low-quality bonds and bonds with long maturities may offer higher yields, but both expose you to greater risk – junk bonds to a greater risk of default and long-maturity bonds to the risk of losing market value when interest rates rise.
Maximizing Total Return
When you want to generate a high total return over the long term, your bond objective is to generate capital gains, which you do by trading – buying and selling bonds before they mature – and reinvesting the proceeds in more bonds. Professional money managers do this in two ways: buying discount bonds in one or more specific maturities.
The prices of existing bonds change as market interest rates rise or fall. When interest rates rise, the prices of existing bonds generally go down, sometimes below their face value. Bonds priced below that benchmark are called “discount bonds.” If an investor buys a discount bond and holds it to maturity at face value, the result is a profit.
Sometimes, similar price advantages emerge among bonds at specific maturities because of inefficiencies in the bond market. Professionals know that there is a pattern to the line that connects yields and maturities known as the “yield curve.” Irregularities can develop in the yield curve that suggest to professionals that prices at a specific maturity are temporarily depressed. While not actual “discount bonds,” the prices of these bonds are expected to increase as the yield curve returns to its normal shape.
When you’re positioning your portfolio, you should concern yourself with maximizing your total return in light of your tolerance for risk. But once you’re retired, many people hold bonds to generate income to support their lifestyle instead of reinvesting the interest. While any portfolio structure will suffice, a “laddered” bond portfolio is often recommended.
To create a ladder, divide the total amount of capital you want to devote to generating income into five to 10 equal parts. Then, invest each amount in bonds of different maturities; and when your shortest-maturity bonds mature, reinvest the proceeds in the bonds with the longest maturity you started with.
A bond ladder’s chief advantage is to keep the interest income you receive more even over the years than it would typically be if all of your bonds mature at the same time. When all of your bonds mature, how much income you generate depends on the rates that prevail at the time. With a ladder, you still control your risk level through the quality of the bonds in which you invest and in the average maturity of the entire portfolio you create.
Your stage in life, your risk tolerance, and your needs for income or total return are all important factors in the structure of the bond portfolio that’s right for you. Please to discuss this in more detail.
Copyright © Integrated Concepts 2013. Some articles in this newsletter were prepared by Integrated Concepts, a separate, nonaffiliated business entity. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.