Bonds are an essential part of any diversified portfolio. Although we generally don’t expect the same high returns with bonds as we do with stocks, there is much less risk. Bond funds can be a great diversification tool since they have low correlation with stock funds. Essentially, that means that the health of the stock market will have little to do with the bond market. Stocks could be soaring while bonds remain relatively neutral or even negative(and vice versa).
But why would any long term investor want to invest in bonds when the market has returned almost 10% year to date(4/9/2013)? Since bonds have a low correlation with stocks, they can reduce portfolio volatility without greatly sacrificing returns. A portfolio of 100% equities should give you the highest return over the long run but who knows how long it will take to achieve those returns. There have been many 10 year periods of negative stock market return and even a few 20 year periods with low returns. Sometimes you get lucky by falling into the right window.
I think holding bonds makes a lot of sense since as your potfolio approaches 100% stocks, the “risk-return” profile becomes less efficient. This chart shows that the returns for a 100/0 portfolio are similar to 80/20 but you take on significant more risk/volatility for a very meager increase in returns. Since my current investing horizon is 40 years from now, I’m pretty aggressive with my allocation at 90/10 stocks/bonds. Most bogleheads would recommend an upper limit of 80/20 for an aggressive stock allocation.
How Bond Funds Go Up or Down
You may already know that when interest rates go down, bond funds go up and vice versa, but do you know why? A bond is essentially an IOU that pays interest at fixed intervals until maturity when you receive the full amount back. So if you purchase a $1,000 bond with a 2% interest rate and decide to sell it one year later when rates have gone up to 3%, no one is going to pay you the full amount for your bond since they could just go out and buy a newly issued bond at 3%. This is the interest rate risk component of bonds.
Duration of a Bond
The duration of a bond is the weighted average of times until the fixed cash flows are received. The duration of a 5 year bond with a 1% coupon rate would be 4.89 years while the duration of a 5 year bond with a 5% coupon rate would be 4.49 years. Even though they both mature at the same time, the latter has a shorter duration since more interest is paid out prior to maturity.
Bond duration is important because when interest rates rise you can easily calculate your potential losses by multiplying the bond duration by the change in applicable interest rate. If you own a bond fund with a 5 year duration and there is a sudden 2% increase in interest rates, your fund would lose 10% of its value. So in today’s low interest rate environment, it doesn’t make much sense to invest in bond funds with medium to high durations since their expected returns are so low. Vanguard Total Bond Market(VBMFX) for example has a duration of 5.18 years which allows you to be right in the meaty part of the “risk-return” profile.
Must Bond Funds Go Down?
I’ve read a lot of articles from popular media lately about the looming “bond bubble” and how it’s time to get out of bond funds now. They claim that since interest rates are so low, they have nowhere to go but up. And since bond funds go down when interest rates go up, it makes sense to sell off your bonds now before it’s too late. But I see two major problems with this argument.
First, we don’t know when interest rates are going to rise. Remember that rates don’t have to do anything, the only thing we know for sure is that they cannot go much lower since their is a mathematical bound at 0. Second, while higher rates can cause short to intermediate term losses, in the long term you are likely to earn higher returns since the new higher rates will eventually offset the losses, and then provide higher returns than if rates had remained low. So realistically you probably won’t ever see the 10% drop mentioned above, since a 2% interest rate increase will happen over a period of months or maybe even years.
Stocks are NOT a Substitute for Bonds
If you’ve decided that the interest risk on bonds isn’t worth it right now, that’s fine, but your other options aren’t a whole lot better. Be careful not to chase yield by substituting bonds for stocks. One popular strategy involves replacing bonds with high dividend stocks since they tend to spit out a consistent 3% yield. But high dividend stocks have a huge positive correlation to the total stock market. As you can see in this article by the Oblivious Investor, you lose all of the diversification benefits of bonds when switching to a highly correlated asset like dividend stocks.
There’s not a whole lot of positive news on the bonds front other than to stay patient and stay the course. Even though bonds won’t be able to mathematically maintain the results of the past 10 years, they provide needed diversification and reduced volatility for your portfolio. As long as you are invested in short to mid duration bonds, your losses will be softened by the slow moving nature of interest rates and the re-investment at higher rates.
It’s very unlikely that you’ll wake up one day and see a 5% jump in interest rates(and corresponding 25% decrease in your total bond market fund) like what could happen with stocks. Instead, rates will probably slowly begin to creep up in the future but we won’t know when.
Readers, have you taken a look at the duration of your bond funds lately? Are you staying the course or chasing yields with dividend stocks or some other investment?
-Harry @ PF Pro
If you’re looking for more resources on bonds, here are some of the books that I recommend(These are amazon affiliate links so if you click and make a purchase I will receive a small commission. Thanks for supporting the site!)
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