The role of bonds in your portfolio management

Some investors think by focusing our portfolio management strategy on stocks, and staying out of bonds and fixed-return investments, we’re missing out on bonds’ ability to lower portfolio volatility.

It’s true that bonds do tend to reduce your portfolio’s volatility, since they tend to rise when stock prices fall. That’s why many brokers sell bonds to their clients. Of course, bonds also generate more commission fees and income for the broker, compared to stocks, especially if you buy them via bond funds and other investment products.

Bonds may make your portfolio more stable in the short term. But they are sure to increase your broker’s income, and reduce your long-term returns. Here’s why:

Portfolio management: Why we recommend that you stay out of bonds

Our view on bonds is a reaction to the times — to today’s economic and investment situation. Up till the mid-1990s, in fact, we routinely advised that as part of their portfolio management, conservative investors should hold anywhere from one-third to two-thirds of their portfolios in fixed-return investments, such as bonds.

Back then, fixed-return investments paid 8% to 10% a year. That was close to the long-term returns available from the stock market. Of course, fixed-return investments leave your portfolio management strategy fully vulnerable to inflation, unlike stocks.

But back in the 1990s, we saw little risk of inflation. In addition, we felt interest rates were likely to move sideways to downwards for an extended period, and that’s a favourable environment for bonds. (Remember, bond prices and interest rates move inversely. When one goes up, the other goes down.)

Fixed-return investments do lack the tax advantages that are available in the stock market, of course. But that doesn’t matter if your portfolio management involves holding your bonds in an RRSP or RRIF. In these and other tax-deferred accounts, the income from these two types of investments are treated the same for tax purposes.

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Bond prices are more likely to move down than up

A great deal has changed since the mid-1990s, however. Bonds yield less than half of what they paid back then. More important, the outlook is for higher inflation and higher interest rates, due to ballooning deficit spending by governments around the world. No one knows for sure what the future holds, of course. But the next big, long-lasting move in bond prices is likely to be downward.

Today, bonds remain within that rising trend that began 30 years ago, in 1980. This rising trend could, of course, continue for 30 more years—anything’s possible. If it does continue, however, it will have to slow down, since bond yields have dropped from 15% or so to below 4%. Bond yields just don’t have that much further to fall.

Portfolio management: If you want to hold bonds, stick with short-term maturity dates

If you are reluctant to hold a 100%-stocks portfolio—and many people are—then one alternative to consider is to keep a portion of your investment funds in relatively short-term fixed-return investments, with maturity dates of a few months to no more than two to three years in the future.

These fixed-return investments will lose value when interest rates rise, but not enough to make a serious dent in their value. You can hold them till maturity, then get your money back and reinvest.

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