Q: When I asked my advisor about the bonds in my portfolio, he told me that they would “stabilize my returns” and “reduce portfolio risk.” So far this year, I haven’t seen much in the way of stability or risk reduction. I’m beginning to think that maybe I should get out of bonds. What do you think?
A: The financial markets have taken a pounding this year, including the venerable investment grade bond market. Normally, bonds are looked to for safety and stability. However, this year has been different. As an asset class, investment grade bonds are delivering the worst total return in almost 50 years.
The fixed income markets play a vital role in the global capital markets. They also play an important role in a well-structured investment plan. Unfortunately, fixed income securities, also known as bonds, are a mystery to many individual investors. This week we are going make a foray into the world of bonds. However, the bond market is so huge and includes such a mind-boggling array of securities, there is no way we will be able to do more than scratch the surface.
Issuing bonds is a way for a government or a company to borrow money. The bond’s issuer sells the bond to investors with the agreement that the issuer pay the investor a certain amount, known as the bond’s principal when the bond matures. Before the maturity date, most bonds also require the bond issuer to make periodic payments of interest, known as coupon payments, usually on a quarterly or semi-annual basis.
Large institutional investors like insurance companies, pension funds, mutual funds and central banks are the largest players in the bond market. Bonds appeal to these large investors for a couple of reasons. First, bonds produce a steady stream of income which balances out the volatility in other parts of the portfolio. Bond income also helps fund specific liabilities investors may have, like pension benefits or insurance claims.
Second, bonds rank higher than stocks when it comes to claims on the assets of a company. Bond interest gets paid before stock dividends and, if there is a bankruptcy, bondholders get paid before stock investors get anything.
A bond’s price moves as interest rates change. As interest rates go up, the price of the bond goes down. Conversely, as interest rates go down, the price of the bond goes up. This relationship can be a little confusing for investors new to the bond market. You can visualize the relationship by thinking of a teeter-totter with interest rates on one side and bond prices on the other. In general, the longer a bond’s maturity, the more sensitive its price will be to changes in interest rates. Therefore, if you are worried about interest rates going higher (as many investors are right now), you may want to avoid buying bonds with long-dated maturities.
A bond’s yield is the return you will earn on the bond if you pay the market price and hold it to maturity, assuming you reinvest the coupon. The bond’s yield reflects several things, including the bond’s maturity, credit quality, liquidity and whether the bond is callable. When buying a bond, you should carefully look at its yield compared to the yield available on similar fixed income investments. If the bond’s yield is low relative to other bonds with similar characteristics, it is probably not your best choice. On the other hand, a bond with a higher yield than its peers may represent an attractive investment opportunity.
Most bonds are traded over-the-counter, meaning they trade privately between dealers and not on a public exchange like the stock market. Because large institutions dominate the bond market, individual investors sometimes do not get the best pricing, so it is common for individual investors to use bond mutual funds. If you want to buy individual bonds, your best bet is to find a reputable broker or advisor who can help make sure that you get treated fairly.
Bonds are a legitimate part of a sound investment portfolio. Whether or not you continue to hold bonds in your portfolio is a tough decision that needs to be made in light of your overall long-term investment plan.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.