Why Bonds Are Important

Remember the cardinal rule of bonds: When interest rates fall, bond prices rise, and when interest rates rise, bond prices fall. As we’ve seen lately, stocks are more likely to grab the headlines, but over time bonds do some of the heavy lifting that can make a real difference in the success of your portfolio. Let’s take a look at a few of the reasons why that is so.

For one thing, bonds generally represent a safer place to put your money. Of course, the downside is you won’t experience the potential return you can with stocks.

This is why most financial professionals recommend some mix of the two, so that your investment portfolio is properly diversified between high risk (with the potential for great reward) and low risk, where your principal can be preserved and you may enjoy modest returns.

A tale of two risk factors

To see the difference in risk between investing in stocks and investing in bonds, a little comparison shopping may be in order.

One of the big advantages bonds have over stocks is that bonds typically take less of a hit during hard times, as the historical numbers show. For example, consider the worst year for stocks and the worst year for bonds over the last few decades, as reported by the investment-management firm PIMCO. As everyone knows, when the recession hit in 2008, the S&P 500 index took a nosedive, plummeting 38%. Compare that to the year of the bond market’s worst performance — 1994. The Barclays U.S. Aggregate Index dropped just 2.9% that year.

The U.S. Aggregate Bond Index over the years has been a strong support in portfolios when the S&P 500 has seen its biggest losses, but we cannot guarantee that phenomenon happens every time.

From December 1980 to July 1982, the S&P 500 index was down 16.5%, whereas the Barclays U.S. Aggregate Index was up 21.6%.

From February 2001 to September 2002, the S&P 500 saw even worse numbers, dropping 38.9%. Barclays U.S. Aggregate Index, though, was enjoying another banner period, up 15.8%.

And finally, from January 2007 to February 2009 — that Great Recession period that many investors would just as soon forget — the S&P 500 dropped an achingly painful 51%. What was the U.S. Aggregate Bond Index doing during that agonizing time for the market? It was gradually climbing along, up 6.1%.

What kind of bond investment is best for you?

So, it’s clear that bonds are an option investors should consider including in their portfolios. But there’s also the question of how to manage that investment — whether to take a passive approach or an active one.

There are arguments for each, but a PIMCO report makes a good case that active management of bonds is definitely worth looking at. That’s because over the 10-year period ending Dec. 31, 2016, active bond managers outperformed passive bond managers by about 50 basis points (about 0.5%).

Year to year, the difference between active and passive management might not be all that significant. But over the long haul, the difference can be dramatic. And, in fact, when bond yields are low, those who take a passive management approach may be more at risk than their active counterparts.

Ultimately, though, these kinds of decisions have to be made by each investor in consultation with a financial professional. So, it is worthwhile to sit down with your adviser to ponder a few questions:

  • How much of your portfolio is currently allocated for bonds, and is that the balance that’s best for you?
  • How will the bonds perform during a rising rate environment?
  • What is the credit quality of the bonds in your portfolio?
  • And what management strategy — active or passive — is the best fit for your investments and your short and long-term goals?

source: kiplinger.com