This is Part II of the blog I did last month – Bonds Behaving As They Should – Part 1. You can catch-up here. We were discussing the recent bond market gyrations and why investors should not be surprised.
So, picking up where we left off…….what does an individual investor want from a bond allocation? My first thought is that it should be helping to achieve a Strategic Goal. Nothing more, nothing less.
SIMC’s Strategic Goals for Bond Allocations in an individual’s overall portfolio:
- Deflationary Hedge. Yes, we have never seen true deflation in my lifetime, but in the future, prices of goods can either be higher or lower than they are today. There are no other options. Most selloffs in the stock market are due to a change in perception - the market starts to see the possibility of Deflation in the future. The result is Stock prices fall and Bond values increase as interest rates decrease. You need to hedge (fancy way of saying remove or lower) your exposure to this Deflationary Risk. Bonds perform this function beautifully.
- Source of Liquidity. The cardinal sin of investing is selling when markets have declined. Under Murphy’s Law, on the occasion that life gives us an unexpected expense, the stock market is also likely to be down. If we do not have some extra “liquidity” we may have to commit the cardinal sin of selling our investments when they are experiencing a temporary decline in value. Ouch.
- Stabilizer for Overall Portfolio Volatility. We all know that stocks are very likely to be the best performing asset class over the long run. So why don’t we just own portfolios that are 100% stocks? The answer is that stocks are also way more volatile than we think. Very few of us can “stomach” the volatility of a 100% stock portfolio. Even very young investors. Bonds are boring and dull, but also serve to lower the gyrations of your overall portfolio.
So, let’s try to analyze a few different types of bonds to see how they measure up against our strategic goals?
These bonds will come at a higher yield than a treasury bond, but as we recall from last week, extra yield always comes with extra risk. In the case of corporate bonds, the big risk is default risk. i.e. the company will declare bankruptcy or go into a restructuring and you will get back only a small % of your original investment. To make matters worse, this is likely to happen when your stock portfolio has also been beaten up by the market.
These are bonds composed of a group of individual home mortgages – just like the name implies. The problem here is that you never know exactly what you are going to get in terms of payments. You will get a pro-rata share of the underlying mortgage payments for sure, but what exactly will it be? When the economy sinks, people may stop paying their mortgages. Do you remember 2007-2009? These babies almost brought the world to its knees. Oh, …and good luck finding a buyer when everyone is trying to figure out what % of the population is going to stop making their mortgage payments.
I could discuss Asset-backed Bonds, Commercial Mortgage-backed securities, exotic Mortgage-backed bond derivatives as well. But I think you get the picture…...complicated bonds all have tricky risks buried inside them, and these risks like to come out during a crisis.
Let’s look at some that do better.
US Treasury Bonds:
These are arguably the safest securities in the world. They form the base interest rate structure from which all other bonds are priced. They do not have any default risk other than that of the US Treasury. Most do not need fancy “enhancements” to find a buyer - people run towards these securities in times of crisis. As a result, they hold their liquidity characteristics better than all other bond sub-sectors in times of crisis. Yes, they still have interest-rate risk, but this is something we can manage and set for a client’s risk profile. These boring old securities sure do a good job at achieving your strategic goals!
The Bottom Line:
Whew, we have covered a lot for a simple blog post. I hope it is clear that an individual’s investment goals may not be a good fit for large swaths of the bond market. One can use small allocations from these riskier bond sub-sectors, but I would want to be sure you have achieved your strategic goals before trying to get too fancy. Most of the time, the plain vanilla US Treasury Bond is all you really need.
This is being provided for informational purposes only, and should not be construed as a recommendation to buy or sell any specific securities. The views expressed are those of Southern Investment Management Collective (SIMC) and do not necessarily reflect the views of Mutual Advisors, LLC or any of its affiliates. SIMC, nor any of its members, are tax accountants or legal attorneys, and do not provide tax or legal advice. For tax or legal advice, you should consult your tax or legal professional. Investment advisory services offered through Mutual Advisors, LLC DBA Southern Investment Management Collective, a SEC registered investment adviser.
About the Author: Kent Fisher, CFA, CFP®
Kent Fisher is a Chapel Hill, NC Fee-Only Comprehensive Wealth Manager at the Southern Investment Management Collective (SIMC). SIMC provides comprehensive financial planning, retirement planning and investment management services to help clients organize, grow and protect their assets. SIMC serves clients as a fiduciary, and tailors all solutions to each client's unique situation