All About Bonds Chapter 1: Why Would Anyone Own Bonds
Here in the first of a series of blogs on bonds we discuss some different types of bonds and a few important things to know about them.
Bonds are an important part of your portfolio, they should exhibit little risk, help preserve capital and hedge against economic downturns. With that said there are several decisions to make regarding bonds. The first is how should they be held in one’s portfolio? You can access them through mutual funds, ETF’s or you can buy them out right. The next decision is what types of bonds should you consider? We will be answering those questions in this series.
What is a Bond?
A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments which are defined in a contract. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. The terms of the contractual agreement defines the bond details including the end date when the principal of
Why Own Bonds in A Portfolio
While Warren Buffet has warned investors that bonds are dead and some strategists agree. They would be right if the only reason to invest in bonds was to achieve return. The yield from a 10-year Treasury bond – the yield was 0.93% at year end which is a decline of 94% from the 15.8% yield investors received September 1981. In fact in some countries like Japan and Germany, sovereign yields are negative so globally fixed income is currently not very attractive. So let’s be clear, we don’t suggest investing in bonds for the purpose of high yields.
Bond investors face a challenging environment. It is important to understand why having bonds in your portfolio is so important even in this low-rate environment. Bonds can improve the diversification (and efficiency) of your portfolio since they tend to be negatively correlated with the market, creating a “zig” when the stock market “zags”. Secondly bonds offer an asset of last resort if you need to liquidate . You may recall us talking about the three bucket strategy, where bonds offer the opportunity to raise cash during a bear market. Selling assets that have declined in value because of a market correction is something to be avoided, especially for those who are retired and depend on their portfolio for income. Third, bonds can offer tax opportunities which we will discuss when purchasing municipalities. And lastly they offer some yield, compared to cash for those tactically waiting for rates to rise since the opportunity cost of missing the compounding effect of yields may prove unwise should low yields last indefinitely.
What Should You Do?
Don’t abandon your bond holdings strictly because of their low yields. Instead make sure you know the role your bonds play in your portfolio and make sure you are holding the right bonds especially if preserving your capital is a priority.