Busting the Myth About Bonds

The old rule of thumb was that the percentage of bonds held in your portfolio should be equal to your age, with the remainder held in stocks. Another way of saying this was the “60/40 Rule”, or 60% stocks and 40% bonds in your portfolio (or vice versa, depending on your age). The purpose of this split was to create a “diversified” portfolio – meaning that when some of your holdings were down, the others were up, or holding steady, to counter the loss. But here are the issues with this portfolio design:

1. Bonds are not created equal.
2. So, not all bonds move in the opposite direction as the stock market.
3. But, bonds do have an inverse (opposite) relationship with interest rates.

Let’s start with the first point – not all bonds are created equal. Bonds are a form of debt owed by either a company or a government body. And just as individuals have a credit score, bond issuers have a rating. In both cases, these scores represent the likelihood that the debt will be repaid. Bonds with higher ratings are considered “Investment grade”, while bonds with lower ratings are called “Junk bonds”. A common trap that investors fall into is choosing lower-grade junk bonds because they pay a higher interest rate (just like those with lower credit scores would). However, these bonds only pay a higher interest rate because there is a much higher risk that they won’t be repaid.

In fact, junk bonds are highly correlated with the stock market, meaning they can be just as risky (volatile), which completely defeats the purpose of holding bonds in order to have a diversified portfolio. In order for a portfolio to be truly diversified, you want some of your holdings to zig while others zag. This will typically create a smoother rider for your overall portfolio balance.

Even high-quality bonds pose certain risks, especially in our current environment. It is safe to say that, at this point, interest rates have nowhere to go but up. The problem here is that bonds have an inverse relationship with interest rates. This means that as interest rates rise, the value of bonds will decrease. It makes sense when you think about it – if I have an old bond paying 2%, but I can get a new bond paying 3-4%, the old bond becomes less attractive and therefore drops in value. Interest rates have the biggest impact on long-term bonds since they are locked into lower rates for more years. Short-term bonds see a smaller drop in value because they will mature faster, freeing up funds to invest into new, higher paying bonds.

Of course, all of this is not to say that you shouldn’t hold any bonds in your portfolio, but if your aim is to diversify your holdings, stocks and bonds alone likely won’t cut it. Instead, your portfolio should represent a variety of asset classes, including stocks and bonds, but also adding exposure to alternative investments, such as real estate, commodities, energy, etc. And, when choosing bonds, consider what you are trying to accomplish with them. High-quality, short-term bonds are typically a safer holding (and the expected returns reflect that) while long-term junk bonds will likely bear a higher interest rate-but at what risk? Non-traditional bonds, such as foreign bonds, have the potential to go increase in value with rising interest rates, unlike traditional bonds.

Remember, a diversified portfolio means a smoother ride in the long-run, but even if most of the holdings in your portfolio are up, some will be down-as it should be. In order for a diversified strategy to work, you should build a portfolio with a purpose and stick with it through the various stages of a business cycle. It is easier to do this when every holding in your portfolio has an objective and you understand what that objective is. This is where working with a financial advisor can really benefit you. We understand the characteristics of each asset class and their correlations and we can help you design a portfolio in line with your goals. In the long run, this will help you stick to your plan and avoid the costly mistakes that a lot of investors often make.