The three roles fixed income investments can play in your investment portfolio
If you have a portfolio manager assisting you with your investments, you probably meet with him or her at least once a year for a thorough review of your portfolio. When you do, the two of you will look at the performance of the securities you own in each asset class—including stocks, bonds, and cash/cash equivalents. If a particular investment doesn’t meet expectations, your portfolio manager will make adjustments to try to improve the performance of that portion of your portfolio, buying and selling securities as appropriate.
At the same time, your portfolio manager will also look at the different roles that these asset classes play in your portfolio—and the amount you allocate to each of them—based on the investment goals you’ve established and your risk tolerance.
The role of stocks is to produce long-term growth through gains in their share prices.
The role for your short-term investments and cash is liquidity: quick and easy access to your money when you need it.
For the bonds you own, there are three possible roles: Lowering overall portfolio volatility; adding stability of principal; and providing steady, reliable income.
Here’s a brief look at the three roles bonds can play in your portfolio, as background to any adjustments your portfolio manager may make during your next review or, in the interim, to respond to changing interest rates.
The potential to lower portfolio volatility
Because the performance of bonds and stocks historically moved in opposite directions, adding bonds to your portfolio was seen as a good way to help diversify risk. So when stock market didn’t perform well, bonds would fill in the gap. In 2002, for example, when stocks lost 21%, 10-year U.S. Treasury bonds gained 15%. In 2008, when stocks lost 36%, 10-year Treasury bonds gained 20%.
Over the past 10 years, however, this relationship has changed as stocks and bonds have increasingly moved in a similar direction in response to the economy and financial markets. For this reason, we cannot rely on them to “hedge” stocks as much as we used to.
Still, the steady performance of bonds can balance the more extreme ups and downs of stocks, with a narrower range of less volatile performance over time. In the chart below, for example, the S&P 500® Index, which represents the 500 largest companies based on market capitalization, had a wide range of possible returns, especially in periods of volatility (as indicated by the orange line). In a typical year, year the index might be down 11% at one point and then finish the year up by 10%.
During that same time period, the range of returns for fixed income investments represented by the Bloomberg Barclays Aggregate US Bond Index (LUGCTRUU) (indicated by the blue line) was much narrower, although lower overall. When combined with the more volatile returns of stocks in an investment portfolio, bonds can have a stabilizing effect.
A way to protect your principal
If held to maturity, high quality individual corporate and government bonds offer a level of certainty that stocks can’t duplicate. Where else can you be certain that you will receive a steady amount of income and get the full amount of your money back when the investment term ends?
If you buy a high quality 10-year bond today paying 2.9%, for example, your return after 10 years will be 2.9% and you will get your par value back when it matures.
That’s why we use bonds as a way to protect a client’s principal in many of the portfolios we manage. We’re also finding that, as demographics change and more people retire, they are more willing to sacrifice some return to protect their principal, which provides further support to the bond market.
The ability to generate income
With bonds, you also receive predictable, regular payments of interest income. So if you hold a 10-year US Treasury bond for the entire 10 years, you will receive payments based on the coupon rate when the bond was issued. This coupon rate is fixed. Hence, the “fixed income” label.
Of course, the income you’ll receive from a bond is only as certain as the entity issuing it. That’s why owning U.S. government securities and high quality bonds is a good strategy if income is your primary goal. High-yield (“junk”) bonds may promise higher returns, but the risk you take with them is more like it is for equities/stocks. There’s no guarantee that the issuer won’t default.
You may be counting on the fixed income investments in your portfolio to fulfill only one of the roles above, such as income or protection of your principal. But, in fact, every bond has the potential to fill all three roles to varying degrees. Your portfolio manager has the tools to select the bonds that make the most sense for your growth, income, and principal preservation goals; for your risk tolerance; and for the changing market and economic environment, including rising interest rates.
For more on how we manage your bond portfolio in periods of rising rates, read Five Steps We Take to Manage Your Fixed Income Investments When Interest Rates Rise.
This article is for informational purposes only and should not be construed as investment or legal advice.
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