Bonds are an oxymoron as they have many conflicting parts. Investors have typically used bonds in the past for ways to provide a relatively stable stream of income, usually in retirement years. They can also be used as a hedge against other investments, such as stocks or real estate, in a diversified portfolio.
But bonds have been getting a bad rap after last year's losses, based on concerns of rising interest rates. This is part of what makes bonds contradictory and confusing - because they often work opposite of a stock or equity investment. Some investors never truly understand the workings of a bond and therefore have a hard time knowing what to expect from this type of a fixed-income vehicle.
A bond is basically a loan or an IOU issued by a corporation or government entity. These are usually issued to raise money. When you purchase a bond, you are giving the issuer your money to use and they will pay you interest in return. Bonds are usually issued for certain periods of time or terms, such as 10, 20 or 30 years.
The longer the term, the more vulnerable you are that interest rates will change over that period of time, and perhaps you could have gotten a better deal with another issuer when interest rates rise. Therefore the value of a bond declines when interest rates rise. This can be due to the fact that your bond is now worth less when you go to sell it because it is still paying last year's interest rate. If you are seeking a more competitive interest rate, then so will the next buyer want that higher rate as well. Therefore, to unload the bond in a rising interest rate environment, you could end up taking less than full value to get rid of it.
Investors hold bonds for two main reasons: to provide income and to provide a hedge against equity based investing. Since a bond is a debt instrument, it has the potential to behave opposite of an equity or stock investment. One main reason this occurs is when there is economic growth, stocks can rise in value along with growing consumerism. When the economy expands due to more spending, interest rates start to rise along with potential inflation and growth. When rates increase, the value of the bond declines, which leaves the bond holder with a lower market value. Therefore, this can be a good diversifier in a portfolio of stocks when there is a stock market correction; some bonds have the potential to increase or act opposite.
The last few years of painfully low interest rates have many bond investors frustrated. They are not getting the yields they are used to and the concern is that when rates do finally rise, their bond values will fall. However, the first few months of 2014 proved this theory wrong. When stocks tumbled, bonds started to recover. This shows that diversified portfolios that hold non-correlated instruments are very important in your portfolio.
If interest rates rise gradually, and at the same time there is moderate and increasing growth in the economy, then bonds could still fare quite well. The shorter duration is less risky and adding other types of equities and alternatives to your portfolio will help keep you balanced. This is a good time to review your accounts with your advisor to determine how much fixed income you need to be represented by bonds and in what duration and yield.
Patricia Kummer has been an independent Certified Financial Planner for 28 years and is president of Kummer Financial Strategies Inc., a Registered Investment Advisor in Highlands Ranch. Kummer Financial is a four-year 5280 Top Advisor. Please visit www.kummerfinancial.com for more information or call the economic hotline at 303-683-5800. Any material discussed is meant for informational purposes only and not a substitute for individual advice.