Bonds are classic components of a diversified portfolio. Over time, Bonds are expected to produce less return than Stocks, and their price and yield (income) is derived from interest rates. Bonds are a hard investment to swallow right now because interest rates are very low, and expected to rise.
2% is a pretty hard number to swallow when we are told about historical levels of 6% or more. The question then arises, can you accept a 2% yield, or do you not need to?
Taking a $10K example.
Assuming broad ETF positions, If you elect a 100% stock allocation your investment will move up 10% when the market does... and also drop by 10% when it drops. You are riding the wave. In this case you'd be up to a high of $11,000, before a 10% loss and end up with $9900...
If however, you elect 70% stocks and 30% cash (zero APR), when the market goes up 10% you'd be up to $10,700, and when it drops 10% $9930.
Bonds in this environment are like cash, but pay a bit more. At 2% yields:
70% stock gain 10% lose 10% = $6930
30% bond gain 2% = $3060
total after drop would be $9990
However... if interest rates rise the price of the bond fund will drop, and it will take several years to recover.
Can both stocks and bonds drop together?
History tells us that bonds and stocks are broadly uncorrelated in movement. However, there is a correlation at this time between bonds and stocks in the sense that quantitative easing and low interest rates are fueling the stock market. The reality is that rates will rise, likely at some point during this year. When they do, that will impact bond prices.. the question is will it impact stock prices also?
Why be in bonds at all?
The examples above show that being in bonds can protect against downward movements of the stock market, in some situations. The real value though is having assets outside of the market when the market drops, and using these to buy stocks at a lower price point. This is the essence of rebalancing a portfolio.
A better question might be, why be in stocks at all? The answer tends to be because people are seeking a return that will leverage wealth to the point where they can achieve their goals. If we forget the stock market for a moment and suggest that everyone invests in long term bonds, yielding around 4% at this time, plans fall apart.
Bonds might be a bad bet with low interest rates, and the impending rate rises, but if you don't have them in your portfolio, what are you doing to stop riding the rollercoaster of the market back down?
- Interest Rates Low= Low Yields
- Interest Rates Rise = existing bond value drops
2% is a pretty hard number to swallow when we are told about historical levels of 6% or more. The question then arises, can you accept a 2% yield, or do you not need to?
Taking a $10K example.
Assuming broad ETF positions, If you elect a 100% stock allocation your investment will move up 10% when the market does... and also drop by 10% when it drops. You are riding the wave. In this case you'd be up to a high of $11,000, before a 10% loss and end up with $9900...
If however, you elect 70% stocks and 30% cash (zero APR), when the market goes up 10% you'd be up to $10,700, and when it drops 10% $9930.
Bonds in this environment are like cash, but pay a bit more. At 2% yields:
70% stock gain 10% lose 10% = $6930
30% bond gain 2% = $3060
total after drop would be $9990
However... if interest rates rise the price of the bond fund will drop, and it will take several years to recover.
Can both stocks and bonds drop together?
History tells us that bonds and stocks are broadly uncorrelated in movement. However, there is a correlation at this time between bonds and stocks in the sense that quantitative easing and low interest rates are fueling the stock market. The reality is that rates will rise, likely at some point during this year. When they do, that will impact bond prices.. the question is will it impact stock prices also?
Why be in bonds at all?
The examples above show that being in bonds can protect against downward movements of the stock market, in some situations. The real value though is having assets outside of the market when the market drops, and using these to buy stocks at a lower price point. This is the essence of rebalancing a portfolio.
A better question might be, why be in stocks at all? The answer tends to be because people are seeking a return that will leverage wealth to the point where they can achieve their goals. If we forget the stock market for a moment and suggest that everyone invests in long term bonds, yielding around 4% at this time, plans fall apart.
Bonds might be a bad bet with low interest rates, and the impending rate rises, but if you don't have them in your portfolio, what are you doing to stop riding the rollercoaster of the market back down?