Bonds are debt instruments that pay investors a steady stream of income in return for their cash up front. But income is only one of the benefits that bonds can add to a portfolio.
In today’s economic environment, many investors are concerned with how monetary policy will affect their bond positions. That’s because inflation typically leads to rising interest rates, and rising interest rates lead to lower bond prices. So, why should investors hold bonds in their portfolios in this environment?
Bonds Provide Reliable Income
When stocks pay dividends, they are based on the financial position of the company when dividends are declared. Dividend payments are often fairly consistent, but in times of turmoil these payments can be reduced dramatically, without notice. Conversely, bond issuers pay fixed coupon payments to their investors for the term of the bond, based on the terms of the initial contract. This means that even in changing business and economic climates, bond coupon payments remain steady.
In addition, with non-dividend paying stocks or other types of investments, you may need to sell a portion of your assets to create income. If you need to sell a security when prices are down, you lock in the loss. With bonds, however, income is paid without having to sell the investment. This means you can keep your bonds and have the option to sell when it is advantageous to do so. In summary, the steady income that bonds generate can be a benefit to any diversified portfolio or retirement plan.
Bonds Help Diversify Your Portfolio
Diversification is a key term that you will hear often in investing. It describes a situation where your funds are spread across different asset classes and types of investments. A properly diversified portfolio will be less susceptible to the volatilities of the markets.
In order to achieve diversification, the asset classes you select must have little to no direct correlation to each other. Fortunately for those trying to diversify, returns on bonds have not historically moved in-sync with stock returns. Specifically, returns on intermediate-term bond funds – which hold a mixture of corporate and government bonds – have had little correlation with returns on large-blend stock funds. This means that the price of a basket of bonds does not move in any discernable pattern when compared to the stock prices of the largest U.S. companies. Because bonds have little correlation to stock prices, holding bonds in your portfolio can provide stability when stock prices fall.
Bonds Can Provide Capital Appreciation
Bonds can be purchased at auction, directly from the issuer, or they can be purchased on the secondary markets. Likewise, bond holders can choose to hold their investments until maturity or sell them on the secondary market before they mature. The secondary market provides an opportunity for investors to earn profits from fluctuations in the values of their bonds. In fact, there is an entire industry built on the capital appreciation of bonds.
Fixed income traders stay active in the bond markets, buying and selling to generate profits. While actively trading bonds probably isn’t a great strategy for your savings, it exemplifies how bonds can provide additional value in a portfolio.
Bonds Can Help Reduce Your Tax Burden
Dividends and interest payments from stocks and corporate bonds are generally taxable as income. However, interest from government bonds can be exempt from some taxation.
For example, municipal bonds — those issued by cities, states, and other government entities, excluding the federal government — pay interest that is exempt from federal income tax. Income from these bonds may also be exempt from state and local income tax depending on where you live and the terms of the bond. In addition, interest from Treasury bonds — those issued by the federal government — is taxed at the federal level but exempt from state and local taxes.
How does the current economic environment impact bond holdings?
Today, inflation is at a multi-decade high. From December 2020 through December 2021, consumer prices increased 7.0%, the fastest pace since 1982. Historically, one of the most common ways to combat rising inflation has been raising interest rates. As such, the Fed recently signaled their intentions to raise rates early this year. When the Fed funds rate rises, market interest rates and bond yields typically follow.
One of the most important tenants of bond investing is that prices move counter to yields. When the market demands higher yields from bonds, new bonds are issued at a higher rate. This devalues existing bonds and leads to lower prices in the secondary market.
Bond Yields are On the Rise
In anticipation of the Fed raising rates, bond yields are already rising. The 10-year Treasury yield increased from 0.93 % at the beginning of 2021 to 1.63% at the beginning of 2022. By January 18, the 10-year Treasury yield had spiked to 1.87%.
So, if inflation continues, and the Fed raises rates as is expected, your current bond holdings may lose value, but that’s no reason to panic sell. While bond prices could fall over the next year, the income that you receive from new bond investments will likely rise in response to higher market interest rates.
Evaluate Your Bond Position with Financial Fingerprint™ by Meld Financial
With inflation diminishing the purchasing power of bond income and pushing bond prices lower, you may consider switching your portfolio to a more equity-focused allocation. Before you do this, it is important to remember the role that bonds play in your portfolio — providing income, protection from downside risk, and adding to your wealth through capital gains and tax benefits.
Financial Fingerprint™ is a comprehensive wealth management plan that is quick to assemble, easy to understand, and simple to modify as your circumstances change. With your Financial Fingerprint™ and an advisor at Meld Financial, you can be confident that you are holding an appropriate level of bonds for your situation.
Contact us today to get started.