Feb 9, 2017 5 min read

While traditional portfolio management has always recommended holding a mix of stocks and bonds, it may be time to reconsider the role of bonds in reducing volatility of stocks.

Bonds are debt instruments issued by government entities or corporations. When you purchase a bond, you are lending money to the issuer for a certain period of time, sometimes for as long as 30 years. In most cases, you will receive interest payments on a quarterly basis and get your investment back at maturity when the period ends. If the issuer were to declare bankruptcy, you could lose your investment.

Since credit default is a risk, entities with poor credit must pay higher rates of interest to attract buyers of their debt. This type of bond is sometimes referred to as a junk bond. Some bonds are sold at a discount and your interest is received from a stepped up face value at maturity. You could still owe taxes each year during this time frame.

Interest rates on bonds are at historic lows. Yields started trending downward in 1981, more than 30 years ago. Today, short-term yields are just above zero.

The main reason for the low rates are because of actions taken by central banks both in the United States and around the world. This was because central banks wanted low rates to try to stimulate the economy by making it less expensive to borrow money to buy a new house, automobile or other major purchases.

Seniors have been hurt by these policies because they have led to not only lower yields on bonds, but low interest rates on bank certificates of deposits. These were often financial products that were important to older investors who wanted to reduce stock market volatility.

Municipal bonds are issued by some government agencies and authorities. They pay interest that is federal income tax free and sometimes state income tax tax-free, depending on where you live and where the issuer is located. These bonds are more risky than bonds issued by bigger entities such as the U.S. government which has its full taxing authority behind them. These should only be considered by people in a high-income tax bracket because the interest yield is usually lower than ordinary bonds. Also, interest you receive from them is considered when calculating provisional adjusted gross income to determine how much of your Social Security income will be taxed. It is also used in calculating the alternative minimum tax.

For decades, investors have used bonds to try to add stability to their market-sensitive investments. In the past, portfolio allocation would increase the proportion you held in bonds as you aged. Over the last 15 years, bonds have performed pretty well. That was because they had huge tail winds behind them. This is starting to change rapidly today.

Interest rates had been decreasing since 1981. Bond values move in the opposite direction as interest rates.

The Federal Reserve has started raising interest rates. They had been near zero for the last six years. When interest rates go up, the value of bonds go down. Bonds with longer maturities will move down faster than short-term maturities.

To understand this point, consider the following scenario: If we owned a 30-year bond paying 2.5 percent and newly issued bonds were paying 4 percent and the credit risk was the same for both bonds, would we want to trade our old bond for a new one? Of course we would.

If we called our broker and told him to sell the old one and buy the one with the higher interest rate, who would purchase the old bond? No one would at face value. Everyone would want the higher rate. The bond issuer does not have to buy it back until maturity and they would never do this voluntarily and issue replacements at a higher cost to them. To sell, we would have to offer a discount that would equate to 4 percent interest to the new buyer.

The tail winds for bonds are also changing because of the large amount of bonds bought by the Fed during quantitative easing. During this program, it purchased many billions of dollars of government debt. Since these securities are sold at auction, the buyer willing to accept the lowest yield closed the deal. This purchasing by the Fed lowered interest rates. At some point, the Fed will have to sell these bonds,which will create a surplus of supply and push up interest rates.

Bond prices will be negatively affected by all of these factors, so you must be careful with you asset allocation. What worked in the past might not work in the future. Bonds will not take the volatility out of your portfolio.

Gary Boatman is a Monessen-based certified financial planner and author of “Your Financial Compass: Safe passage through the turbulent waters of taxes, income planning and market volatility.”

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