Where Do Bonds Fit in Your Investment Plan?

There's no simple answer to whether you should own bonds.

March 20, 2014 -- Conventional financial wisdom holds that bonds are an essential part of any portfolio. But while bonds can play an important role of adding security, whether to include them – and if so, at what level – isn’t an automatic decision.

Current economic conditions don’t favor making many types of bond investments. But even for the long term – in good economies and bad – determining asset allocation to bonds is a complex undertaking that varies with the individual. You should start by asking a critical question that should apply to every component of your portfolio: What role do you expect bonds to play and why? To answer that question, you must understand the risks, advantages and dynamics of bonds and the different types of bonds and bond products accessible by most investors.

The right bond investments can play the important role of capital preservation and risk management for investors, including many women who, as a gender, tend to have a lower risk tolerance than men. This tendency has served women well because, studies show, they tend to make fewer investing errors than men.

Yet, the notion that all women or men should necessarily have a substantial part of their portfolios in bonds stems from the myth of the average investor — a plain-vanilla, typical investor. In my practice, I’ve never met that investor. Each investor is different, so it doesn’t make sense to average their characteristics together and come up with a one-size-fits-all recommendation that actually applies to few people.

For example, I have a middle-age client who chooses not to own bonds and instead owns an otherwise diversified portfolio that includes stocks and alternative investments (natural resources, real estate and international stocks). I support his decision because this suits his situation. He can do without bonds because his substantial “bond-like” income is secure and he has ample cash reserves to protect him from damage due to severe dips in the stock market. He also has a high risk tolerance. I wouldn’t recommend a bondless portfolio to people with shorter time horizons, insecure income, lower cash reserves or a lower risk tolerance.

Many people believe that as soon as they turn 65, they must cash in stocks and convert their entire portfolios to bonds to eliminate risk because of fears that the stock market will crash. Ironically, in doing this they’re creating longevity risk – the risk that their resources won’t keep pace with expenses over the next 20 or 30 years. So, in focusing too much on bonds, they trade one risk for another.

They make this mistake because advisors have traditionally recommended an increasing percentage of bonds in portfolios as investors age. This recommendation is based, in part, on the widespread belief that bond prices aren’t correlated with stock prices — that their prices move in opposite directions. But this isn’t necessarily the case with corporate bonds, whose prices move in the same direction as these companies’ stocks far more often than is generally understood.

Numerous studies point out periods when stocks and bonds have indeed been correlated, and you don’t need a Ph.D. in finance to know that this happened in 2008 with corporate bonds. If you had investments in stocks and corporate bonds then, you still remember the pain from declines in both. (However, government bonds and international bonds did well in 2008, providing portfolio relief to those who owned them.)

And, for a given company, think about it: If the company is doing well, shouldn’t its stocks and its bonds reflect this? I worked for years as a corporate controller and chief financial officer, and I learned that if a company is doing great, you want to own its stock to get returns that reflect this growth. If you just own the company’s bonds, there’s a cap on what you will get even if the company is growing like gangbusters. If the company goes belly-up, bondholders might get paid before stockholders, but they may get pennies on the dollar. And regardless, you can minimize your chances of being in this position by carefully assessing credit quality.

Though I’m generally not a big fan of corporate bonds, they can play a role in portfolio diversification if they’re chosen carefully: the right companies (different companies than the stocks you own) with the right maturities.

By contrast, the price movements of U.S. Treasuries and other government bonds don’t tend to correlate with those of stocks. So, despite their lower rates compared with corporate bonds, they can play a defensive role in a portfolio and provide protection against down stock markets to preserve capital for the long term — assuming you keep maturities low to protect against rising interest rates.

Even as they approach retirement, some investors reasonably choose not to keep much of their portfolios in bonds. This may not be a bad decision, depending on their individual situations. The person who may not need bonds, even as they get on in years, has good income, maintains a substantial emergency fund to pay living expenses, is in good health, plans to work indefinitely (perhaps they own a business) and tends to be an aggressive investor with a high risk tolerance. When such individuals choose to own few bonds or even none, they may be making the right decision.

So on one hand you have the risk of a stock market decline damaging your portfolio, and on the other, the risk that bonds may not deliver the level of returns necessary to reach your retirement goals. Though no investors should exceed their individual risk tolerance, weak returns — such as those from Treasuries because of their low rates — pose the potential for losing buying power over time if they represent too great a percentage of a total portfolio. Loss of buying power is related to the documented generalized fear of many women that they may end up destitute in their later years.

One way to balance returns and risk in bond investments is to consider the broad spectrum of bond types available to individual investors. For example, municipal bonds — issued by municipalities, water and power authorities and other local entities — can give investors good returns with manageable risk, plus the advantage of keeping returns free of federal taxes and state taxes, provided you live in the state where the issuing entity is located. Traditionally only accessible to wealthy investors because high investment minimums precluded diversification for the average investor, these investments are now accessible to the typical individual investor through exchange-traded funds (ETFs).

Some ETFs also offer solutions for investment in domestic bonds as preferable alternatives to bond funds where managers create problems for investors by buying and selling holdings.

Whether this or any other type of bond product or bonds works for you is up to you to decide. Remember: In investing, there is no one size of strategy that fits all. You must find what works for you, depending on your situation, your goals and your risk tolerance.

Any opinions expressed her are solely those of the author.

Laura Mattia is a partner with Baron Financial Group, and a fee-only financial advisor. She's a Certified Financial Planner professional (CFP®), a Chartered Retirement Plan Specialist (CRPS®) and a Certified Divorce Planner (CDFA™) and holds an M.B.A. in accounting/finance. Her Internet radio show is Financially Empowering Women™ with Laura Mattia. A professor at the Rutgers University Business School, Mattia is completing a Ph.D. in financial planning from Texas Tech University; her dissertation is on how to help women plan for retirement.