Chances are, if you have a financial advisor, they’ve already harped on the importance of including bonds in your investment portfolio. But, for the 12 months ending February 2022 the U.S. inflation rate was 7.9%, while 30-year treasury bonds are yielding just over 2.5%. Through that arbitrage you are “losing” money in the form of diminished purchasing power. So, again, WHY is it so important that bonds comprise a piece of your portfolio?
When boiled down to the most fundamental elements, the answer is two-fold … and neither has to do with relying upon bonds as the driver of returns.
First, owning bonds is a risk management tool. Bonds are a form of debt issued buy a company or institution, and therefore the issuer has a contractual obligation to pay interest and return principal to the bondholder. In contrast to owning stock (where the company has no obligation to return principal nor pay interest), bond prices fluctuate far less. When allocated properly, this reduction in volatility allows investors to experience a much smoother ride through full market cycles.
Mitigating volatility in this way may not be the top priority in a young investors approach. But, with every step closer to retirement it becomes increasingly important. Young investors have decades to earn income, save, and allow their investments to rebound from negative performance periods. Retirees and those approaching retirement can ill afford such risks. If their portfolio is too aggressively invested in stocks (equities) during a major negative market event, there may not be enough time for the portfolio to recover or to increase savings before the lost funds the diminished funds are needed. With that in mind, it is critical to have bonds that anchor the portfolio against the riptides that are market corrections and recessions.
The second fundamental need for bonds in your investment portfolio is optionality. Bonds provide retirees a stable pool of investments to draw their income from when the market is down. Selling equities when the market is down is the quickest way to permanently reduce your “principal”.
More broadly, having an allocation to bonds provides all investors with a source of “dry powder” to deploy when the market is down. Having the option to take funds from bonds (that have likely retained more value than stocks) and invest those funds in stocks that are now more favorably priced can have exponentially positive results. Especially in comparison to an investor that rides out the market cycle purely in stocks from top to bottom and back again.
In summary, while it hurts to watch inflation outpace the interest paid on your bond portfolio – it is critical to stay the course. The stability and optionality provided to your portfolio are invaluable characteristics that are very difficult to replicate with other assets. However, the right mix of stocks and bonds in your portfolio is dependent on your unique goals, circumstances, and retirement timeline. If you have any doubts about where your portfolio stands, please don’t hesitate to reach out.
P.S. It is worth mentioning that we are in a unique market environment – specifically due to the historically high inflation levels. In more historically “normal” market environments, the gap between bond yields and the prevailing inflation rate is often far less detrimental than it is today (if not favorable). Just another reason to remain disciplined in your bond allocation.
