Article Written By: Angela R. Berkosky, CFA
With interest rates around the world near record lows, some investors have been questioning if bonds still have a place in investment portfolios. The current interest rate environment can falsely lead investors to eliminate or reduce bonds in their portfolio. Some investors make the assumption that since rates will eventually rise, their bonds will lose value. However, this viewpoint does not take into account the multiple roles that bonds play in a well-diversified investment portfolio.
One of the more common purposes of holding bonds is income generation as most bonds pay a periodic interest or coupon payment to the bond holder. This predictable income stream can be helpful to investors who may be drawing funds from their portfolio to fund living expenses or other cash outflows. Investors can also include bonds in their portfolio with targeted maturity dates to meet specific cash needs. While some investors argue that stocks can also provide income through dividend payments, companies pay dividends at their discretion and can reduce or stop dividends at any time. Bond issuers, however, are obligated to fulfill coupon payments.
Diversification & Capital Preservation
Bonds can also serve as a lower-risk, diversifying anchor against market volatility. Some bonds, such as government or investment-grade corporate bonds, are lowly correlated to the equity market. As the capital markets rise and fall affecting the value of your equities, an allocation to bonds typically dampens the volatility of your overall portfolio. This is a very important characteristic of bonds, as preventing a large drawdown in your overall portfolio helps not only preserve capital, but also compound wealth over time.
Hedge Against an Economic Downturn
Bonds may also be included in portfolios to provide a cushion in economic downturns. For example, when economic growth slows, prices of goods and services stop rising and may even fall, leading to lower inflation or perhaps deflation. The income generated by bonds then becomes even more attractive as bondholders can theoretically buy more goods and services with the same level of income. This typically leads to increased demand for bonds and a subsequent increase in bond prices, which adds to the returns of a diversified portfolio that includes an allocation to bonds.
Putting It All Together
A common misconception among investors is that simply investing in any fixed income security diversifies your portfolio and lowers your overall risk profile. However, there are many different varieties of bonds available in the capital markets, and each has unique characteristics and a distinct risk profile. While interest rate risk is usually the most common risk discussed in today’s bond market, other risks to consider include credit risk, default risk, and liquidity risk.
At Domani Wealth, our investment philosophy centers around building diversified investment portfolios that are in alignment with our clients’ financial goals. Should you have questions on your investment portfolio or wish to meet with one of our wealth advisors, please contact our office.
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