Evaluating the bonds in your portfolio: Are they doing what you think they’re doing?

We all know that we need to invest to achieve our long-term financial goals, right? But are we confident in knowing how to invest?  My last several blog posts have been about making smart decisions with your portfolio that will help you maximize your return, minimize fees, and manage your risk.  Today, I’m going to talk about bonds—not the nuts and bolts of how they work, but how to decide if your selections are meeting your goals.

Stocks or bonds?

When we think about portfolio allocation, one of the first questions most investors ask is how much to put in stocks versus how much to put in bonds. They’ve been told that they need both for long-term success. 

Targeted Date Funds, now the most common investment choice in 401(k)s, usually consists of a total US market stock index fund, an international stock index fund, a US market bond index fund, and an international bond index fund.   The percentage invested in each depends on how long it is until your retirement, relegating more to bonds the closer that you get to the date. 

But what is the point of adding bonds, and is there a set allocation schedule that is right for everyone?  Many investors don’t really understand the key differences between stocks and bonds and how each work in their overall investment strategy.  They just know they should have some of both.  I’ll admit that I didn’t know the nuts and bolts of how bonds worked until I did my master’s degree in finance.  I’m not going to go into the details of that here, although I am planning on giving a primer on bonds in an upcoming post.  Rather, my aim today is to just help you understand what bonds do for your portfolio and to be sure that the bond funds you choose are accomplishing that goal.   

Why add bonds?

In my mind, there are two reasons to invest in bonds:

1.      For the income

2.      To decrease volatility (risk)

In a nutshell, a bond is a loan.  You are the lender (the bond holder) and the company or government is the borrower (the bond issuer).  Like any loan, you give them your money to use with the expectation to be paid back in full and to collect interest in the meantime.  That interest is called the yield and is usually paid every 6 months. The rate is fixed at the time that you purchase the bond (the coupon rate).  If you hold it through its entire term (maturity), the issuer pays you back your loan in full, and you keep the interest that they paid you along the way.  

This is why bonds are known as fixed income investments.  If you purchase the bond directly from the issuer, you know all the terms ahead of time—i.e. how much you gave, how much interest you will collect, and when you get the principle back.  Your only risk is that the bond issuer goes bankrupt and cannot pay you back.  If the risk of that is higher (lower rated company, longer term loan), you should be compensated with a higher yield.

The predictability of these terms is very useful if you are retired and living off your investment income.  The checks that you are collecting from your bonds replace your salary and it is easier to budget if you know exactly how much will be coming in.

The secondary bond market

Most people don’t invest in bonds that way though—where they buy the bond directly from the company or government.  Instead, they buy it through brokers on the secondary bond market.   Just like the stock market, there is a huge market where individual bonds are bought and sold. There are index funds, ETFs, and actively managed funds that contain only bonds or a mix of stocks and bonds according to various strategies. 

When you purchase a share of these funds, you don’t hold the individual bond certificates, and the terms aren’t fixed for you.  What you can expect in terms of yields is just an average of the holdings in that fund.  And the value of bonds that are traded on the secondary market fluctuate, which means that you could earn or lose money on that initial investment. 

I won’t go into detail here about how bonds are valued other than to say that their price is inversely related to interest rates.  As interest rates go up, bond values go down and vice versa. 

Using bonds to manage risk

That leads me to reason number two to invest in bonds: to decrease volatility.  Although bond prices fluctuate on the secondary market, they typically do not do so to the same degree as stocks.  Volatility (ups and downs) is a main measure of risk in investing.  Stocks are more volatile and therefore riskier compared to the bond market. There is a higher chance that, depending on the timing of buying and selling, that you could lose money in the stock market, especially in the short term. So, adding bonds to your portfolio can temper some of that risk.  That is particularly important for money that you might need within the next 10 years or so. 

Evaluating the bonds in your portfolio

So, when considering the bonds in your portfolio, you should judge them based on the two reasons that they should be there in the first place—generating income and decreasing volatility.  Here are some of the things to look for:

1.       Look at the annual yields. This is how much interest you are being paid by the fund every year.  You can easily find the information on Yahoo Finance. It is reported as a percentage, and the amount of money going back into your account depends on how much is invested in the fund.  If you are investing for the income, that number is going to be very important to you because that is your “salary”.  If you are reinvesting it for the future, it will just go to purchase more bonds and raise your invested net worth.  You should compare it to the dividends of your stock funds (also reported as annual yield).  Bond yields are almost always higher.  If they are not, then it’s probably not the best fund. 

If you have a bunch of different bond funds, you need to understand what type of bonds they are invested in because the type of bond will impact the expected yields.  Usually, the shortest-term bond funds are pretty comparable to money market returns.  The longer the maturity, the more interest you should get because the risk is higher.  Also, compare types of companies, governments, and international funds.  The riskier the company or government, the higher yield you should get.  If the yields are not higher, you are not being compensated appropriately for taking on more risk. 

2.      Look at the 5-year return. This is only applicable if you are buying and selling bonds on the secondary market. If you are buying the bond directly from the issuer, the return is 0%.  (You just get back what you lent at maturity along with whatever interest you were paid along the way.) Bond funds on the secondary market can appreciate or depreciate, the same as a stock.  When comparing them to a stock return, remember to average out the 5-year return to an annual return and add the yield.  Do the same for the stock with its dividend. This should give you a better comparison.   

3.      Look at the volatility. Bond funds will report a beta, just like stock funds.  I’ll refer you back to my article on alpha and beta as a refresher on what that means. It is basically a measure of risk compared to the S&P 500.  Your bonds should have a beta significantly lower than 1.0.  If it is not,  then you are not accomplishing one of the two major purposes for owning bonds in the first place—lowering your volatility.  In that case, you should really compare the combined appreciation of the returns and the yields against a comparable stock fund. 

4.      Look at the expense ratios. Don’t pay more for an actively managed bond fund unless it is outperforming its relevant index by more than the expense ratio. For more on expense ratios, check out my previous post here.

Putting it all together

The point of investing is to make you as much money as possible when factoring in your timeframe, future income needs, and risk tolerance.  One way to balance some of the competing factors is allocation between stocks and bonds.  But don’t just do it because someone told you that you should.  Try to understand why you are doing it and strategize accordingly.  Then, it is much easier to look at the bonds in your portfolio and decide if they are appropriate for you.  Do you need them for current or near-future income or is it more to smooth out the volatility in your portfolio? How long will it be before you retire when your income needs will be higher and risk of a down market more impactful?  Those are the kinds of questions you should be asking.  Then, look at your individual bond selections and compare the yields, the beta, the returns and the fees and be sure that they are doing the right job. 

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Disclaimer: the material in this blog post is intended for general educational purposes only and should not be considered specific financial advice. You should always consult with your personal financial advisor to see how it might fit within your personalized financial plan.