Using Bonds to Generate Income and Diversify Your Portfolio
A frequently asked question we hear from investors is “what role do bonds play in my portfolio?” Although bond portfolios are vital to overall asset allocation, they often are viewed as uninteresting in comparison to their flashy stock counterparts.
This is unfortunate because bonds can play a key part in building a diversified and balanced investment strategy for certain investors. Read on to discover the benefit of using bonds and why you may benefit from adding them to your portfolio.
The Rise of the 60/40 Portfolio
In the 1980s, the 60/40 portfolio rose to popularity. This ratio of 60% stocks to 40% bonds has historically offered a host of benefits to investors, including managed risk, lower volatility and total returns in line with key benchmark indexes.
While the 60/40 mix is a good starting point for building a portfolio, it’s not a hard-and-fast rule. Some investors may benefit from a higher or lower stock to bond ratio, depending on their risk tolerance or timeline. The primary goal is to diversify your assets – and bonds can be a key component for reaching that goal.
The Benefits of Bonds in a Diversified Portfolio
The goal of a diversified portfolio is to avoid concentration in any single investment or asset class, with the intent of reducing volatility and sudden price swings. How do bonds help investors achieve that goal? Let’s take a look:
Bonds can potentially lower portfolio volatility.
Stocks can often swing wildly in price due to various factors: geopolitical events, company earnings, or simply the market’s mood. Bonds are generally less sensitive to these factors and are much more likely to remain stable. This is because the value of a bond is tied to its interest payments and principal value at maturity, rather than to the underlying performance of the issuer. Their steadier nature can help cushion the impact when stock prices dip, reducing overall portfolio volatility.
Bonds offer a reliable source of income.
Unlike stock dividends, which fluctuate, bonds offer fixed interest payments at regular intervals. When an investor buys a bond, they are essentially lending money to the issuer of the bond, whether it be a government or corporation, and in return, they receive regular interest payments for the life of the bond. This interest, also known as the bond’s coupon rate, is typically paid out semi-annually or annually, and can provide a steady source of income for investors seeking regular cash flows from their investments. This predictable income stream can be especially valuable for investors seeking additional income. Bonds also have a maturity date, at which time the investor receives their principal back.
Bonds open new opportunities to diversify.
Five main types of bonds exist: Treasury, savings, agency, municipal and corporate. Each bond has its own level of inherent risk and potential return due to varying credit ratings, maturities and interest rates. Adding a mix of bond types to your portfolio allows you to further diversify and mitigate potential risk even more.
Bonds can serve as a hedge against inflation.
Certain bond types, such as Treasury inflation-protected securities (TIPS), are designed to adjust their principal value during periods of higher inflation. The bonds’ principal amount is adjusted based on changes in the Consumer Price Index, with interest paid twice a year at a fixed rate applied to the adjusted principal. Keep in mind, however, that bonds that don’t mature for 20 or 30 years could potentially suffer from inflation risk, since their fixed payments won’t stretch as far when costs rise.
Bonds can be used to invest in your community.
Municipal bonds are issued by local, county and state governments, who use the proceeds to pay for schools, hospitals, roads and bridges and emergency services. Many investors purchase these bonds for the dual benefits of generating income and supporting the communities in which they live.
Are bonds a good fit for your portfolio?
You may benefit from the addition of bonds to your portfolio. To learn more, request your complimentary consultant with one of our experienced advisors today!