In terms of popularity, bond portfolios typically rank behind stock portfolios. Despite their crucial role in overall asset allocation, bonds don’t seem to be getting as much attention as their more active stock-based cousins. They are often constructed after the fact, or remain the same for years, generating revenue. This is unfortunate, because bonds offer a hybrid — sharing and blending the risk and reward characteristics of stocks and cash.
A properly constructed bond portfolio can provide income, total return, diversify into other asset classes, and can be as risky or as safe as the designer intended. The world of fixed income is as diverse and exotic as the stock market.
- Bonds are an important part of a balanced portfolio.
- Bonds generate higher returns than bank accounts, but the risk of a diversified bond portfolio is still relatively low.
- Bonds in general, and government bonds in particular, can diversify a stock portfolio and reduce losses.
- Bond ETFs are an easy way for investors to gain income from their bond portfolios.
How Fixed Income Portfolios Work
First, bonds are designed to provide bondholders with income in exchange for lending money to the issuer. The path for the issuer to pay the coupon is passed on to the transfer agent, the bank and the bondholder. In its simplest form, a 3% bond with a face value of $1,000 traded at par would earn the holder $30 (3% of $1,000) annually in coupon form.
It’s easy to forget that the word “coupon” used to refer to the actual coupon cut from a bond. Back in the 20th century, bondholders would receive a coupon book with the bond attached, and they could go to a bank to present a coupon for a payment or deposit. This process has evolved to not only make it easier to buy and sell bonds, but also to earn coupons as income. Bonds are now held in so-called street names, providing an easier and safer way to own bonds.
Bonds can also be used in accounts as collateral for loans, including margin loans used to buy other bonds, stocks, and some funds. Bonds are versatile and an excellent liquidity tool to achieve your investment goals.
Bond Income and Taxes
Bond income can be taxed at federal rates or exempt from federal tax. In addition to this, there are many differences in taxation at the state and local level. Generally, bond income is taxed as income, whether declared as an individual or a company. This is a disadvantage for bonds, as people who like stocks will cite the current bond market producing negative real returns.
While this sounds impossible, here is an example:
This example shows a principal of $100,000 invested in a bond paying a 4% coupon, taxed at the federal and state levels. After deducting the loss of purchasing power from the 3% consumer price index (CPI) value, the real rate of return is negative. However, note that there is some controversy about using the CPI as a measure of inflation.
On the other hand, using coupon bonds that are tax-exempt at the federal and state levels yields different results:
It is also possible to avoid tax on bond income by placing it in a tax-free retirement account, such as a Roth IRA.
How Bonds Benefit Investors
While positive, a 1% return isn’t very impressive given the potential gains in the stock market. These examples may quickly drive novice investors away. But there’s a reason why both individual and institutional investors need bonds as part of a balanced portfolio. The main reason is that coupon income is only one component of the total return of a bond portfolio. Furthermore, the low correlation of bonds as an asset class with equity asset classes provides some stability through diversification.
The total return of a bond portfolio is the overall change in its value over a specified time interval, including income and capital appreciation or depreciation. Market value fluctuations and ultimately risk characteristics are influenced by interest rates as measured by the yield curve. The interest rate environment is dynamic. So the source of returns is not just the prevailing interest rate on the static yield curve. It also includes price changes caused by interest rate fluctuations over time.
As an asset class, bonds help to diversify an overall portfolio because they are less correlated with other asset classes. A lonely bond portfolio always shines brightest when the stock market is tumbling. While correlations vary widely over time, bonds are not highly correlated with any other asset class. Bonds can reduce volatility in even the simplest of diversified portfolios because they have a low or negative correlation with stocks. The more investors know about diversification, the more likely they are to add bonds to their portfolios.
ETFs make bonds easy
Investors don’t have to be a bond geek or learn how to be a bond trader to buy bond ETFs. Bond ETFs can be purchased like stocks, giving investors instant access to ready-made bond portfolios. Aggregated bond ETFs provide access to the entire investment-grade bond market. They are ideal for investors who are looking for relatively low risk and higher returns than currency markets. However, those who want to protect their stock holdings are better off using government bond ETFs. The price of government bonds usually rises when stock prices fall, so they offer more protection.
Bonds are often seen as a less glamorous partner to stocks. Many investors think bonds are boring and complicated, but ETFs make them easy. The bond market also has a lot of interesting options. Buying U.S. government bonds during a bear market in stocks can be more lucrative and exciting than waiting for cash. When investors expect the bear market to end, junk bonds are often a higher-reward and lower-risk option than stocks. In the end, a highly diversified bond portfolio is an easy way to make more money than cash but with more risk.