The Role of Bonds in a Portfolio

When markets become more volatile, it is a good time to reflect on the role of bonds in a portfolio. While we do not recommend reacting to short-term changes in market movement, we do think it is a good time to examine the characteristics and function of different portions of an investment portfolio. When stock markets are rising, bonds appear to be an anchor holding back performance. However, when stock markets are falling, bonds can cushion losses and provide stability.

There are typically three different roles for bonds in portfolios: income, principal protection, and downside protection or diversification.

I. Role of Bonds

A. Income

Bonds pay their holders coupons which provides a source of income. The coupon is set at the issuance of the bond, and the yield on the bond is based on its market price based on the current interest rate environment. Interest rates have been at historical lows for several years, and the interest earned on short-term bonds has been modest. For this reason, bonds have not been providing their traditional role of income in a balanced portfolio.

Investors can receive higher yields for primarily two reasons: term risk and credit risk. Long-term bonds typically pay a higher rate of interest due to the potential for interest rates to fluctuate over time. Bonds with lower credit quality, for issuers that are more likely to default on their obligations, typically have higher interest rates, referred to as a “credit spread.” Investors sometimes hunt for yield by settling for lower quality or longer term bonds that pay higher rates of interest than shorter term higher quality bonds.

B. Principal Protection

The issuer of a bond promises to pay back the face value of the bond at maturity. Depending on the credit quality of the issuer, this promise to make repayment at maturity provides protection of principal for the holder of the bond. This feature can be particularly important for investors who need money in the short term to meet certain obligations, as well as protection for investors seeking to reduce the potential risk of loss in their portfolio as a whole.

This “return of principal” feature is also important when establishing bond ladders to meet the spending needs of an investor over time. When a bond matures, the money is spent and it is gone. Long-term investors seeking some level of protection for an entire portfolio typically reinvest the proceeds of maturing bonds.

C. Diversification / Downside Protection

Bonds also provide a diversification benefit in portfolios. This downside protection is provided because bond prices tend to rise in times of distress when stock prices are falling. This relationship does not hold in all circumstances, nor does it hold for all bonds. U.S. Treasuries are generally considered the best protection in times of distress as they become more in demand by those seeking to take less risk.

Unfortunately, when interest rates are very low, the benefit of diversification from a bond decreases. The sensitivity of a bond to changes in interest rates is based on its duration, which is the average maturity of the payments that the bond makes. The longer the duration, the more sensitive the bond is to fluctuations in interest rates. For example, a five-year treasury with a duration of approximately five years would decline in value by 5% for every 1% increase in interest rates. The same is true when interest rates fall, the same bond with a five-year duration would increase in value by 5% for every 1% decrease in interest rates.

When interest rates are very low, the potential increase in the value of the bond in the short term due to decreases in interest rates is limited by the lowest interest in income that a bondholder would demand. While not impossible, it is hard to imagine a scenario where a five-year treasury would yield no income. Given that interest rates are already very low and the typical demand for longer term bondholders for some income, the downside protection of bonds appears to be mismatched with the potential losses incurred as interest rates rise.

II. Questions an Investor Should Ask

Given these three roles of bonds in a portfolio, an investor needs to consider what percentage of bonds they should hold in a portfolio. When we try to help investors determine the level of risk that they are willing to take, we typically frame this risk in the form of two questions.

A. What is the largest loss you would be willing to take in this portfolio?

We ask investors what is the largest loss they would be willing to take in their portfolio without abandoning the investment plan that they adopt. For example, some investors might not tolerate losing even 10% of their portfolio, while others could not tolerate losing “half of their money.” Bonds, and the protection to principal that they provide, can be particularly helpful.

In the case of an investor not willing to tolerate more than a 50% loss, one could easily hedge that risk by putting half of the portfolio in bonds. However, that investor might also take some additional risk in stocks in that portfolio if they were willing to tolerate even steep declines there. The stock market, as measured by the S&P 500, suffered an almost 55% decline during the “Great Recession.” While the past is certainly no indication of the future and the market could lose more than 55% during some future financial crisis, an investor might be willing to factor in that level of loss in designing a portfolio.

For example, a portfolio with 60% in stocks and 40% in high quality bonds would suffer a 30% loss on the entire portfolio if the entire stock market had a 50% decline and the bonds remained even. This 30% loss would keep that investor above the threshold of “losing half your money.” That portfolio would have to lose more than 80% in its stocks before it fell below a 50% total loss, assuming no decline in the bond portfolio.

B. How many years of spending do you have in safe assets?

We also encourage investors, particularly institutions that rely on their endowments for funding basic expenses as well as individuals at or nearing retirement, to look at the size of their bonds based on the number of years of spending they provide. For example, an investor withdrawing 5% of their portfolio would have a 20-year horizon on their account, assuming no real returns over the period. At the end of that 20 years, the portfolio would be exhausted. If half of that portfolio was in bonds, that would mean that that investor would have approximately ten years of their portfolio in “safer assets.” The role of the risky portion of the portfolio is to replace the purchasing power spent over that ten-year period during the next ten years.

The problem starts if there is a multi-year decline in the stock market, as has occurred in the past. That ten years of protection could become only five years and it would be even harder for the remaining risky portion of the portfolio to replace future spending needs. Thinking of the bond portion of the portfolio as the number of years in safe assets is an effective rule of thumb for many people. It also highlights the need to have many years in safer assets in order to dampen the risk of more volatile portions of the portfolio. Ultimately, there is no guarantee that the stock portfolio will be able to replenish spending, but that is a risk return tradeoff that every investor must consider.

III. Concluding Thoughts

While we do not recommend that people react to short-term movements in the market, we do think it is a good idea to reflect on your portfolio strategy when markets are not doing well. It is easier to take risks when the market is going up, but market downturns test our willingness to take risks. A typical course of action is to wait for the “market storms” to subside a little (assuming they do!) and then remember what we were thinking in the height of the storm and adjust our long-term portfolio accordingly.

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