Diversification, Asset Allocation & the Role of Bonds in the Portfolio: Part 3
In our previous blog post, we discussed diversification and asset allocation as key ingredients in building a portfolio to target performance and reduce risk, helping you reach your goals and tolerate volatility. Bonds play a key role for many investors.
The Role of Bonds in your Portfolio
Bonds are different than stocks. Stock ownership is where you are a part owner of a business, and you participate in the successes and failures. Bond ownership is where you are the lender to a business, person, or government. As you likely know from borrowing money to buy a car or a home, there is a lot of paperwork, and it seems like you are signing over your life with the bank. When you own a bond, you are the bank. You are the lender. You earn interest payments, then get your money back after the term ends, just like a bank. One difference is that many bonds are interest-only, with no principal. You get your principal back at the end of the term, not during the payment period. A bond typically has a lot of protections in place so that you have some assurance you will get your money back. You don’t have those same assurances with a stock, so bonds are often less risky. Of course, there are risky bonds, too, so you need to know what you own.
An investor typically holds bonds to diversify and have a low or negatively correlated asset in their allocation. It does double duty. This allows you to dampen your risk.
Do Bonds still work as portfolio protection?
The short answer is “Yes”. The actual covenants in a bond provide some protection from a significant loss. But, bonds' diversification and asset allocation benefits are highly dependent on prevailing interest rates. With record low rates, bonds do not provide as much portfolio protection during volatile times as they do now. And the interest doesn’t give you much of a rate of return. So, why even own them? They still provide some protection, especially for certain types of bonds. They still have a role in a portfolio to reduce risk so an investor can tolerate the volatility of stocks. But that protection is not as powerful as it has been in the previous decades.
What to do?
Perhaps nothing, but this is why investors hire a financial advisor. We help our clients balance risk and reward and alternative ways to protect a portfolio while still achieving your target performance. As a fiduciary advisor, we must act in our client's best interests, and our compensation is based on the value of the portfolio, not the assets our clients own. Our Team can help.
The content of this blog is for informational purposes only and should not be construed as investment, tax, or estate planning advice. Skyline Advisors, Inc. is an SEC Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where representatives of Skyline Advisors, Inc. are properly licensed or exempt from licensure. If indices are referenced in marketing material, it is important to note that these cannot be invest in directly, any vehicle such as Passive index-based ETFs and Mutual Funds which attempt to replicate indices have internal expense ratios and other associated costs that would negatively impact returns. No advice may be rendered unless a client service agreement is in place. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital.
