“The Role of Bonds in Your Portfolio”

When developing your investment allocation, both stocks and bonds have a role to play. The role of stocks is to provide growth over the long run. Stocks have historically demonstrated that risk and return are related, and that stocks have generated higher rates of return than bonds.

The role of bonds, or fixed income, is twofold: to help reduce risk in a portfolio and to generate income. Your financial goals and where you are in life determine which of these roles is most important. Typically someone in his or her working years, saving for retirement and other goals, is not looking to generate income and is more concerned with overall return and mitigating risk. On the other hand, someone who is retired typically is concerned with the income stream the bonds generate.

One of the problems investors have been experiencing is that interest rates are extremely low. While this is good for borrowing money, it is not good for bond yields. In an effort to increase the interest rates investors are receiving, many have turned to high yield bonds, or junk bonds. Based on information from Morningstar, Inc., the average 12-Month Yield on High Yield bond mutual funds was 10.28% as of September 30, 2002. For comparison, the same yield for intermediate term high quality bonds was 4.66%. But is this the appropriate strategy to be taking? In order to answer that question, we have to go back to the two roles of fixed income we discussed earlier: risk reduction and income. While high yield bond funds certainly help to achieve the goal of income, they do not aid in the role of risk reduction. Investors who purchase high yield bond funds must understand that they are investing in the debt of corporations who have very poor credit ratings, and that their risk of default is much greater than companies with a sound financial picture. This is particularly true in an economic climate like the one we are currently experiencing. While the interest yield on high yield bond funds has been 10.28%, the value of the bonds has declined more than that for 2002, creating a negative overall return. In years like 2002, when stocks are performing poorly, bonds should be the part of your portfolio that you can count on for stability. High yield bonds do not fulfill that need.

It is important to understand that risk and return are related, both for stocks, and for bonds. One interesting thing that history points out, however, is that there is more of a reward for taking risk with stocks than there is with bonds. Part of developing an investment allocation is determining the level of risk you are willing to take. It makes sense to take the risk on the stock side of your portfolio, where you have the opportunity for the most reward, and to invest in high quality bonds or bond funds with your fixed income portion. An investor looking for additional income can look for stock asset classes that have higher dividend payouts, such as US Large Cap and Large Value stocks, as well as International Large Value stocks. Because of the stock decline over the last few years, the dividend yields on these securities have increased substantially. These stocks also have more growth potential than an investor would get by using junk bonds.