Fixed income, more famously termed as bonds, rarely get the love they deserve, for a variety of different reasons. This post will center on the importance bonds play in your portfolio, no matter your age.
In order to fully educate on bonds, we must first understand what a bond is. There are many types of bonds – the most common are – and to keep it simple, we will focus on corporate bonds.
A corporate bond is a loan, taken out by a corporation, available for purchase by an investor. Throughout the year Disney (DIS) set the example of a corporation that has continued to tap the bond market in their attempts to raise cash. Essentially, a corporation announces they will be raising cash in the form of a bond offering. This means investors can buy a contract from a corporation, with terms ranging from interest payments (often referred to as coupons) to maturity dates. If you buy one bond from Disney for $1,000, Disney will pay you the interest agreed upon in the contract. For this example let’s say Disney’s offering was a 2% interest rate, paid semiannually for 10 years. So you give Disney $1,000 and they agree to pay you 2% of $1,000 twice a year for the next 10 years. When the 10 years are up, you receive your initial $1,000 back, and you’ve collected $200 in coupon payments along the way. You can understand how buying a bundle of 10,000 bonds from Disney (an investment of $10,000,000) is good for both you (you receive coupon payments of $200,000/year for 10 years) and Disney (they’ve raised the cash they’re looking for).
So why on earth would a corporation hand out interest payments, then agree to send your initial principal back? Well, it’s because they believe that whatever they are raising the cash for will produce a higher return than the interest they are paying you, the bondholder. If a corporation like Disney raises $100,000,000 in a bond issuance, and pays out 2% interest on that money, it’s because they believe the new park they’re building (or whatever that $100M is meant for) will make their company substantially more money over the long-term.
Bonds are a corporation’s way of financing their future.
Now, I know what you’re asking: “Thomas, why does that make bonds an attractive investment for me?”
Why Bonds Are Attractive
- Risk Mitigation: While no investment is completely void of risk, bonds are considered safer than stocks because of the contractual agreement by the issuing organization to not only pay the bondholder interest, but to also reimburse them with their initial investment at the end of the term. These are two “promises” that a stock does not make.
- The Size of the Market: The U.S. bond market is enormous. In fact, it is estimated to be valued around $10 trillion higherthan the U.S. stock market. Size is important because it offers up the opportunity for more liquidity and marketability. This means if you ever need to sell a bond holding, there’s a strong chance someone is willing to buy it.
- Rebalancing Tool: This is perhaps the most important and functional purpose of a bond in a long-term investor’s portfolio. Bonds, since they historically move opposite of stocks, are the ideal vehicle to use in times of equity volatility. Let’s walk through an example where the investor, instead of holding individual bonds, owns the U.S. Aggregate Bond Index Fund (ticker AGG):
- Say you started with a $500,000 portfolio made up of 70% global equities ($350,000) and 30% bonds ($150,000). You’ve been invested for three years in this 70/30 mix and have a moderate gain in your overall equity portion (+5%) and a small gain in your bond portion (+2%). With these gains embedded, your portfolio is now worth $520,500.
- Now, let’s illustrate equity volatility. A global event – a pandemic, perhaps – causes your equity holdings to plummet over a 4-week time period, and your overall equity portfolio drops 10% from where it is now. At the same time however, investors are fleeing to a safer, more steady investment – bonds – and your bond holding appreciates from +2% to +4% in this same time period.
- What now? Well, you have options, of course. You can wait it out and do nothing – the traditional buy and hold strategy. You can panic, sell your equities, and go to cash until the volatility temporarily subsides – permanently locking in losses in your account. Or you can take advantage of the opportunity.
- In our business, this is exactly what we call opportunistic rebalancing. The idea is simple. You lock in the gains you’ve achieved – in this case it’s the +4% uptick in your fixed income holding and use that gain to purchase more of your long-term holdings, at a discount. You are literally following the number one rule in trading – buy low, sell high.
- By doing this you’re accumulating more shares of your long-term holding, at a cheaper price. You’re not losing your principal, subjecting yourself to sequence of returns risk, or panicking. You’re sticking to your plan and gobbling up more shares of equities when they become more attractive. This scenario does not exist without your position in fixed income.
“Risk comes from not knowing what you’re doing.”
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Diversification and asset allocation do not ensure a profit or guarantee against loss.
The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
The views expressed are those of BerganKDV Wealth Management. They are subject to change at any time. These views do not necessarily reflect the opinions of any other firm. Investment advisory services and fee-based planning offered through BerganKDV Wealth Management, an SEC Registered Investment Advisor.
 Retrieved on 12 October 2020 from: https://finance.zacks.com/bond-market-size-vs-stock-market-size-5863.html
 Retrieved on 12 October 2020 from: https://finance.zacks.com/dont-bonds-stocks-move-together-4999.html