The Role of Bonds in a Portfolio

With yieldsYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. below 2%, do bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. still play a role in an investor’s portfolio? And are investors becoming too complacent? Here’s what Chairman Dan Wiener said in our latest webinar,  Booster Shots, Market Shocks and the End of Fed Intervention:*

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Dan Wiener:

I fear investors are becoming a little complacent, throwing some of their caution to the wind and adding risksThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. to their portfolios before the risks become apparent.

Why do I think this? Well, there’s been a lot of recent interest in bitcoin and the new bitcoin futures ETFsA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). For example, one popular ETF tracks the companies in the S&P 500, so buying a share of the ETF gets an investor exposure to all 500 companies in the index., SPACs (special purpose acquisition companies), meme stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. and leverage strategies where investors borrow money against their portfolios to boost their potential gains. All of these, to me, are signs of excessive risk-taking. I don’t believe you need to take extraordinary risks to become wealthy. I do believe, however, that if you take extraordinary risks, you have to accept the fact that you riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. extraordinary losses. And I think a little bit of math shows you what I’m talking about. While a 10% loss only requires an 11% gain to recover from, a 20% loss requires a 25% gain and a 50% loss requires a double, or 100%, return.

Many commentators flagged the fact that both stocks and bonds fell in September. The correlation may leave the diversified risk-aware investor in a bit of a pickle. If bonds aren’t going to protect you from falling stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. prices because they’re falling as well, what’s the value in owning bonds in the first place?

Remember, bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. prices and yields are inversely related: When yields are falling, as they were for about 40 years, bond prices go up. But when yields are rising, as they’ve done over the past year or so, bond prices fall. So while bond prices may be falling, and bond mutual fund prices with them, the yields offered by newer-issue bonds are rising. And they can compensate for some—and sometimes all—of a fund’s price decline, particularly as you extend your time horizon. Also, while bonds have enjoyed a remarkable tailwind over the past four decades, I’ve never been a believer that wealth is created by investing in bonds. But wealth is protected by investing in bonds. With that caveat, I’m not going to give up on bonds as a shock absorber in a diversified portfolio.

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