The Basics of Bonds: What You Should Know before You Invest
Investments and Asset Management
By Jason Krupa MBA, CIMA® - Vice President, Asset Management
Bonds have long been a prominent component of all but the most aggressive investment strategies. Their prices have not typically fluctuated as much as stocks. In addition, they have historically offered returns that are not highly correlated with those generated by stocks. In other words, when stock prices have declined, bond prices have often not declined as much or have even risen. Conversely, when stock prices have risen, bond prices have tended not to rise as much or have even declined. Of course, this is exactly the reason why many investors include both stocks and bonds in their portfolios. By doing so, they diversify their holdings and hopefully, reduce price volatility while smoothing out returns over time.
Recently, however, bonds have fallen out of favor with some investors. Yields have shrunk to historic lows, causing many to wonder whether they should reduce their allocation or even abandon bonds in favor of other investments.
Here is what you should know before you make your decision:
Unlike stocks which represent ownership in a company, bonds are essentially loan agreements issued by companies, governments and municipalities. Like any loan, they feature a maturity date and an interest rate that determines the amount of interest you will receive each year. In addition:
- The security of a bond depends on the creditworthiness of its issuer. To help you assess creditworthiness, independent rating agencies like Standard & Poor’s and Moody’s analyze bonds and assign ratings to them.
- Bonds are also subject to market risk. If you sell a bond before it matures, you may find that the price you receive is higher or lower than that which you paid.
- Bond prices fluctuate according to interest rate levels. When rates go up, bond prices go down and vice versa. For example, imagine you bought a bond when it was first issued that pays 5% a year. It’s now a few years later and interest rates have risen to 6%. As a result, new bonds are now paying 6%, while your old bond pays only 5%. That means it is no longer as valuable as when you bought it, so when you sell it, you’ll incur a loss.
Of course, when is the last time you’ve seen interest rates at 5 or 6%? Rates and many bond yields are now considerably lower and have been for years. That is why some investors are questioning the viability of bonds in today’s environment.
All Bonds Are Not Alike
US Treasury Bonds are backed by the full faith and credit of the United States Government and are, therefore, considered to have far less credit risk than bonds issued by corporations. However, this comparative safety comes with a price.
The average yield of US Treasury Bonds with ten-year maturities was only 0.89% in 2020. Of course, that year was problematic in many respects, but 10-year Treasuries haven’t yielded much more in the previous several years:
30-year Treasuries haven’t fared much better, yielding an average of 1.56% last year and 2.58% the year before.
However, US Treasury securities are not your only alternative when considering bonds for your investment portfolio. Corporate bonds offer higher yields and lower-rated corporate bonds offer higher yields still. In fact, companies rated BBB- or lower by Standard & Poor’s or Baa3 by Moody’s are generally referred to as “high yield bonds.” In addition, the US is not the only place to look for this component of your portfolio. Many investors have shifted at least a portion of their allocation to developed and emerging markets around the world and have allocated assets to sovereign bonds – those issued by various governments – and corporate bonds issued by world-renowned companies.
The question is how can you identify bonds that offer the potential for higher yields without excessive credit, interest rate, or geopolitical risk? At Lenox Advisors, we take an active approach to fixed income management, researching the universe of global fixed income managers for those who bring a combination of solid performance, attention to risk, and organizational strength to the clients they serve.
How Much of Your Portfolio Should Be Allocated to Bonds?
Clearly, the answer depends on a number of factors, including your goals, timeframe, and perhaps most importantly, your risk tolerance. Traditional investment thinking has considered a portfolio allocated 60% to stocks and 40% to bonds to be appropriate for many investors with moderate risk tolerance and a desire for long-term asset growth. In today’s low yield environment, however, many clients are asking us whether this approach still makes sense. With yields so low, they reason, perhaps they should allocate a greater portion of their portfolio to stocks, especially since the equity market has performed so well over the past decade.
The chart below tells a revealing story. It compares the performance of the S&P 500 Index Fund to a balanced portfolio allocated 60% to that fund and 40% to 10-year Treasury Bonds. The timeframe covered is August 31, 1976 (the day the fund was introduced) to August 31, 2019.
As you can see, the index fund returned an average of 11.22% each year, while the balanced fund wasn’t far behind, returning an annual average of 10.25%. Even more revealing is that the balanced fund actually returned 91% of the S&P 500 results with only 47% of the risk.1 What’s more, the balanced fund never experienced a single year with a double-digit loss or a negative return over a 5 or 10-year period.2
Clearly, bonds in this example have done their job, reducing risk while contributing to overall return. Does that mean you should maintain a 60-40 allocation in your portfolio?
Your allocation is a function of where you are in life. If you are retired and seeking income to help meet day-to-day expenses, you might allocate more of your assets to bonds. If you are younger and hoping to accumulate assets for retirement or other long-term goals, you might consider allocating more to equities. Your Lenox advisor can help you determine an allocation that is appropriate for you. They will also work with you to implement your allocation with carefully selected investments that are actively managed in an effort to take advantage of prevailing market conditions and minimize credit and interest rate risk.
1 Risk in this example is measured by beta, a statistic that compares the volatility of an individual stock with that of the overall market. The S&P 500 Index Fund represents the overall market and therefore has a beta of 1.00. During the time period in which the comparison took place, the balanced fund had a beta of .47. In other words, the fund experienced only 47% of the volatility experienced by the S&P 500 Index Fund.
2 The 60/40 Portfolio Will Outlive Us All, Advisor Perspectives, November 11, 2019.