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How Bonds Are Vital to a Successful Portfolio

Bond prices fluctuate differently than stocks. This is mostly because they pay regular interest to investors. So, no matter how the bond’s price changes, the owner can expect that semi-annual pre-determined interest payment until the bond matures. Also, at maturity, the investor can expect to get a full payment for the principal amount.

These two factors are important. Most common stocks don’t offer regular dividend payments or a guaranteed pay off at some future date. This is one reason why some bit of news can alter a stock’s price in minutes or seconds. Simply, there is no cash income stream to offset the uncertainty of stock ownership. Stock prices can fluctuate wildly at certain points. (For more, see: 5 Basic Things to Know About Bonds.)

With bonds, cash income helps offset bad news but it doesn’t necessarily eliminate fluctuations. Known income streams (cash interest and payment in full upon maturity) offer certainty, but they don’t offer absolute certainty. Bonds can default and there is no assurance that a lengthy stream of payments will stay competitive over time. How is that 2% bond payment going to feel a few years from now when new bonds are paying 3%?

The Variables That Matter Most

Although daily prices fluctuate for all bonds, they are most dramatic with two variables. The longer a bond has until maturity, the more dramatic the fluctuations. That’s because there is higher risk that the income stream may become uncompetitive or insufficient. Also, some bonds face a much higher prospect of default than others. A corporate bond issued by a troubled company will see more price volatility than a bond backed by the U.S. government. A long-maturity bond offered by the U.S. government will fluctuate more than a short-maturity one.

Rising interest rates are always bad for bonds, no matter how good they are rated by Moody’s. It’s simple math. If you own a 10-year government-backed bond today, it will pay 2% each year until 2027. But new bonds maturing in 2027 may pay higher rates. If so, you are stuck holding a 2% bond in a 3% environment. Anyone you try to sell it to will want a hefty discount. Longer bonds are worse, shorter bonds are better. None of that has anything to do with the rating, but low-rated bonds will do even worse in this kind of environment.

Bond ratings are important because they are an independent assessment of the issuer’s financial situation. Rating agencies (Moody’s is the best known) study a company’s books and issue a bond grade based on financial stability. In the bond world, U.S. government-backed bonds are the gold standard for safety and carry a AAA rating. From there, bonds move down to AA, A, BBB, BB and below. BB or above are considered investment grade. Although ratings can change - a good company gets hit with a major lawsuit - ratings don’t usually change due to the daily news or current events. Most rating changes reflect a shift in the issuer’s financial condition. (For related reading, see: The Importance of Diversification.)

Choosing and Monitoring Bonds

So why would anyone ever buy a longer or lower-rated bond? Because they pay higher interest. That’s called reaching for yield and it works best when rates are stable or falling. In other words, pretty much the last 20+ years.

So, among bonds, there will always be some fluctuation in prices. But the amount of fluctuation can be controlled through deliberate choices about the actual bonds or sectors held. Similarly, they can be controlled through the bond maturity (computed by a statistic called duration in a bond portfolio). Within maturities or sectors, bond prices usually fluctuate within a range. That range (again, usually) is much smaller than a stock portfolio. Proper bond portfolio design requires the same deliberate process as stocks.

Most long-term portfolios feature both stocks and bonds and the design should be appropriate for each client’s situation and objectives. It is important to remember that stocks and bonds each play a role for diversified portfolios, and that they “play well together.” Often, they exhibit opposite responses to the same piece of news, but even if they go up or down together, their rates of change can be vastly different. For all these reasons, choose and monitor the bonds side of each portfolio, just as the stock side.

Bond Funds

For many investors, it makes sense to hire expertise for bond portfolios. It’s so much more efficient – a few million dollars in bonds could easily be 100 or more individual bonds. With different ratings and maturities, that’s a lot of moving parts for that portion of a portfolio. Plus, and this is quite important, volume matters a lot in the pricing and trading of bonds. A quality mutual fund or unit trust manager likely supervises billions in bonds. They monitor and trade for a mere fraction of the cost for retail investors. Also, quite important again, volume suggests expertise with bonds that can’t be duplicated by amateurs. Much like stock portfolios, I often recommend several different managers for different segments of the bond markets.

Good bond managers won’t have a crystal ball, but they will respond as needed within specified portfolio segments. Although the specter of rising interest rates has been with us for years, it’s impossible to predict the timing or magnitude of changing rates. Rates will rise, but the when and how much are unknown.

Bonds are often neglected in investment portfolios. The main reason is that they are retained more for balance than return. Their primary role is to mitigate portfolio volatility from growth assets, or stocks. Generally speaking, the more bonds, the less portfolio volatility. As ballast, their returns are less important than their stability.

Understanding how bonds work is one key to portfolio success. It’s a mistake to ignore this vital segment of portfolio construction. (For more from this author, see: How to Create a Low-Risk, High-Return Portfolio.)