Bond portfolios usually take a back seat to stock portfolios when it comes to popularity. While they play an important role in overall asset allocation, they just don't seem to get the same attention as their much jazzier stock-based cousins. They are often constructed as an afterthought or just sit untouched for years, generating income. It is unfortunate, because bonds provide a hybrid - sharing and blending the risk/return characteristics of stocks and cash. (Read more about asset allocation in Asset Allocation Within Fixed Income.)
Properly constructed bond portfolios can provide income, total return, diversify other asset classes and be as risky or safe as the designer desires. The fixed-income world is even more diverse and exotic than any stock market ever was. (For related reading, see Creating The Modern Fixed-Income Portfolio.)
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Role of a Fixed-Income Portfolio
First and foremost, bonds are designed to provide income to the bondholder in return for lending the money to the issuer. The path of the coupon payments from the issuer passes through the issuer (ex., governments, municipalities, publicly-held corporations, private placements), the transfer agent, the bank and ultimately the bondholder. In its simplest form, a 5% bond with a face value of $1,000 that is trading at its par value would yield $50 (5% of $1,000) of income to the holder each year in the form of coupons.
It's easy to forget the word "coupon" used to mean actual coupons that were clipped from the bond. Earlier in the last century, bondholders were given a coupon book with their bond and could go to the bank and present the coupon of payment or deposit. This process has evolved, making it much easier not only to buy and sell bonds, but to receive coupons as income. Bonds are now held in what's called "street name", which provides easier and safer holding of the bonds.
The bonds can also be used in an account as collateral for loans including, margin loans to purchase other bonds, stocks and some funds. Bonds are quite versatile and are excellent liquid vehicles for meeting investing goals and objectives. (Read about the high-risk/high-reward world of margin investing in Finding Your Margin Investment Sweet Spot.)
Bond income can be either taxable at the federal rate or exempt from federal tax. Beyond that, there are many variations of taxability at the state and local levels up to and including intangible tax. This form of tax has been as heavily debated as estate tax and will most likely go by the wayside in the future. (Read more in Get Ready For The Estate Tax Phase-Out. To learn more about taxable bond income, read Bond Taxation Rules.)
In general, bond income is taxable as income whether filing as an individual or company. This is a disadvantage for bonds, as folks who favor stocks will quote that the current bond market yields a negative return. While that sounds impossible, here's an example:
This example shows a principal of $100,000 invested in a bond paying a 4% coupon, taxed at the federal and state levels. Deducting the loss of purchasing power with a Consumer Price Index (CPI) value of 3% nets a negative real rate of return. (Read more about using the CPI to calculate inflation in The Consumer Price Index Controversy.)
On the flip side, using a bond whose coupons are exempt from taxes at the federal and state levels creates a different outcome:
Why We Still Need Bonds
While positive, a 1% return is not very impressive, considering the potential returns in the stock markets. While the initial reaction to these examples would drive the novice investor away, there are reasons why both individual and institutional investors require bonds as part of a balanced portfolio. The main reason is that coupon income is only one component of the bond portfolio's total return. In addition, the low correlation of bonds as an asset class with the equity asset classes provides some stability through diversification.
A bond portfolio's total return is the total change in the value including income and capital appreciation or depreciation over a specified time interval. Market value fluctuations, and ultimately risk characteristics, are affected by interest rates as measured by the yield curve. Since the interest rate environment is dynamic, the source of the return is not only the prevailing rate on a static yield curve, but the change in interest rates over the time period or horizon.
As an asset class, bonds help diversify the overall portfolio because of the low correlation to other asset classes. The lonely bond portfolio always shines brightest when equity markets slump. While the correlations vary widely over different time periods, overall, bonds are not highly correlated with other asset classes besides in general. Even in the simplest form of a diversified portfolio - one with three asset classes: stocks, bonds and cash - bonds can reduce volatility due to cross-correlation with the stock portfolio. (Read more about this type of diversification in Diversification Beyond Equities and Diversification: It's All About (Asset) Class.)
Like Tonto and Robin, bonds have typically been viewed as a less-glamorous side-kick to bonds, and have been portrayed as a boring way to invest. But there are actually a lot of options in the bond market, and bonds can be a great way to both earn income and mitigate risk.