Bonds have traditionally acted as a bastion of stability in a portfolio. They are resilient to market fluctuations, and can provide a modest but reliable source of recurrent income. But given that interest rates are most likely going to rise in the next few years, bond prices are slated to fall. Do they still have a role to play in your portfolio?
What Are Bonds?
A bond is basically a loan made to companies or governments. They generally pay a fixed interest rate over a set period. It is effectively an IOU which can be transferred to different parties. When you buy a bond, you are taking over a loan made to the company. You will receive regular payments from the company until a date stipulated in the bond contract. If you would like to know more, Forbes has a nice write-up on it.
How Are They Valuable To You?
They are very valuable whenever there is a market downturn. When equity prices drop drastically, bond prices will tend to be stable, and continue to provide recurring income. This has immense psychological value and tactical value.
Psychological value
Your portfolio is a lot more stable than a 100% equity portfolio. Portfolio value fluctuates less, thus there is a lot less emotional cost. When stocks drop > 5% and your bond values barely changed, you would feel much less of a hit. You would be able to sleep better and make less impulsive decisions.
Tactical value
You have the option of selling away your bonds to take advantage of depressed equity prices. The recurring income is also more assured than the dividends from equities.
Why Are They Less Favorable During This Period?
Interest rates are projected to rise over the next few years. This would make bonds less attractive, as the interest rates they pay out (ie. yield) would be closer to general market rates. For example, a yield of 3% would seem very attractive compared to a 0.5% fixed deposit rate, but not so if compared to a 2.5% fixed deposit rate.
Are They Still Useful During This Period?
Yes – personally I feel they are still useful and relevant to any portfolio. Their psychological and tactical values are not totally nullified by the rising interest rate environment, and they are still extremely valuable during periods of heightened volatility. The key is to select bonds which are less affected.
- Short duration bonds (bonds maturing in < 2 yrs)
- Bonds with relatively high yield, perhaps > 4%, and having its yield adjusting to inflation
The key risk to consider is that rates increase faster and in greater magnitude than expected. This would put more downward pressure on bond prices. Balanced against that is the chance that inflation recedes, and interest rates remain low, which would improve the outlook for bonds.
If wholesale bonds in $250k denominations are not your cup of tea, you can consider bond funds/ETFs. As always, please do not invest 100% of your portfolio in a single asset/asset class, and select reasonably safe bonds from entities which are not in financial distress.