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.
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.
How a Fixed-Income Portfolio Works
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 five percent bond with a face value of $1,000 that is trading at its par value would yield $50 (five percent 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 and Taxation
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. 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 four percent coupon, taxed at the federal and state levels. Deducting the loss of purchasing power with a Consumer Price Index (CPI) value of three percent nets a negative real rate of return.
On the flip side, using a bond whose coupons are exempt from taxes at the federal and state levels creates a different outcome:
How Bonds Benefit Investors
While positive, a one percent 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: It's All About (Asset) Class.)
The Bottom Line
Like Tonto and Robin, bonds have typically been viewed as a less-glamorous sidekick to stocks, 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.
(For information on alternative ways of investing in fixed income, read Bond ETFs: A Viable Alternative.)