The roles of bonds change according to investors' needs

Published: Monday, May 26, 2014 at 1:00 a.m.
Last Modified: Saturday, May 24, 2014 at 4:40 p.m.

Many investors are torn about whether to have a portion of their portfolio in bonds. They know that, over reasonable periods of time, like five years or more, the probability is very small that bonds provide returns equal to or greater than stocks. On the other hand, they know that the stock market occasionally will drop by 20 percent or more and not recover for several years.

This conundrum leaves investors in a quandary over how much, if any, bonds they should own

To start addressing these issues, let's look at how corporate bonds work by contrasting them with how stocks work. Common stock represents a share of ownership in a corporation; bonds formalize a loan to the corporation. Instead of ownership, the bondholder has a contract to be paid interest and, by some specified date, to be repaid the full amount of the loan.

The bonds of a given corporation have less risk than the stock of the corporation because a bondholder knows exactly when she will get her interest payments, how much they will be, and by when she will receive her entire original investment back. Only bankruptcy can deny her these.

A stockholder has no such knowledge. The price of the stock may never return to what she paid for it. And dividends may be cut or eliminated by a vote of the board of directors.

So investors should consider having bonds in their portfolio because they:

Want a source of income that is more certain than dividends and more predictable than capital gains.

Want to lower the volatility of their portfolio to balance their investments in higher-volatility stocks.

Want a source of capital to take advantage of equity-market declines. This is possible because high-quality bonds tend to be negatively correlated to equities (they rise when equities fall).

Let's consider some the types of investors and the role, if any, that bonds can play in their portfolios.

The first investor is a retiree who has a large stock portfolio and adequate income so she doesn't foresee having to dip into her portfolio to pay bills. This investor should probably eschew bonds completely. Her investments have a long-term horizon, and she can withstand the stock market's natural volatility. Similarly, a younger investor with 30-plus years to retirement should also eschew bonds for many years.

Contrast this with a second investor, a retiree who needs to make withdrawals, say 10 percent annually, from his portfolio to maintain his standard of living. (This large a withdrawal is dangerous, but we will ignore that issue for this example.)

He can't afford to have all his money in stocks because if, early on, the market does poorly for several years, when the market recovers his withdrawals might have shrunk his portfolio so severely that it can't recover. Something like a 50/50 stock/bond portfolio might be appropriate, with a diverse mixture of intermediate-term corporate bonds at the core of the bond portfolio.

Consider a third investor who believes that the market is overvalued but needs some income to pay her bills. She doesn't want to be heavily invested in stocks because she believes the market is ripe for a fall, but CDs don't provide enough of a return for her needs.

Again, holding about a 50/50 portfolio might provide an appropriate risk/return balance.

As a final example, consider a young couple that is saving to make a major purchase in the next few years. They would like a reasonable return but can't take any risk with their principal. Because of their short time horizon they can't invest heavily in stocks -- they can't accept the market's volatility risk. For them, a portfolio of individual bonds or bond funds matching their time horizon is appropriate. Anything more than about a 10/90 stock/bond portfolio would be too risky and could compromise reaching their goal.

To summarize: Bonds belong in some investors' portfolios, not all investors' portfolios.

For more, follow me on Twitter @logicalinvestor.

Send comments and questions to Robert Stepleman, Business News, Herald-Tribune, 1741 Main St., Sarasota, FL 34236, or Follow him on Twitter @logicalinvestor. Past performance is not indicative of future results. The data and performance information is for informational purposes only is not intended as a solicitation.

This story appeared in print on page D12


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