If you think bonds are boring, think again! While this type of investment rarely gets mentioned, it will offer your portfolio critical protection during volatile times like these. Learn how you should diversify your portfolio with bonds in today’s podcast episode, and see the full transcript below.
Welcome to the Pacifica Wealth podcast. This is Robert Pagliarini.
Stocks have been the focus over the past couple of months. When you hear about the “market,” they are referring to the stock market. When they discuss that the “futures are up” or the “futures are down,” they are talking about stocks. Everybody wants to talk about stocks, but there is another type of investment that is also very important and that makes up a large percentage of your portfolio that rarely gets a mention — bonds. Why?
Stocks are exciting. They make big moves both up and down (sometimes even in the same day!). And bonds? They are typically much more subdued. If you were a Brady Bunch fan, “Marcia, Marcia, Marcia” may come to mind. Yes, bonds are the Jan Brady of the investment world. But don’t take their lack of headlines to mean they are not important or are always safe. In fact, not all bonds are created equally. This last quarter is a prime example of that.
So here’s what happened in the first quarter of 2020 with different types of bonds:
- Emerging market bonds were down almost 15%
- High yield bonds were down over 10%
- Corporate bonds were down almost 5%
- US Treasury bonds up almost 5%
There’s a huge difference in their performance in just a three month period. And you thought bonds were boring.
What’s going on here? Not all bonds are the same. Although stocks are known to be volatile, bonds – especially certain kinds of bonds – can be just as volatile. How does this affect your portfolio?
I view bonds as a source of income and as a ballast in a storm. I want my bonds to zig when stocks zag – to offer some protection and to minimize the overall volatility of a portfolio. The last thing I want is to think I have a diversified portfolio of “safe” bonds and stocks only to discover that my bonds were down 15% in a month!
The bonds we use in our client portfolios have held up well. Why? We don’t generally invest in emerging market bond or high yield bond funds. Although these types of bonds may provide a slightly higher yield, with that extra yield comes a great deal of risk. My philosophy is that if you want to take risk with your bonds you might as well just buy stocks instead.
If you’re retired or approaching retirement, there are three things I want you to look at in terms of the bonds in your portfolio:
1) The Type of Bond
I talked earlier about emerging market bonds, high yield bonds, corporate bonds, and treasury bonds. There are mortgage-backed security bonds and different types of bonds that you can own. Your job is to look at the type of bonds that you have in your portfolio.
My guess is that you don’t own individual bonds. You probably own bond funds, which is absolutely fine, it’s acceptable, there’s nothing wrong with that. In fact, I would encourage that. But I want you to understand the type of bond fund that you own. What types of bonds do they purchase?
You can go onto Google Finance or Yahoo! Finance, type in the symbol, and it will tell you the type of bonds that you have. I would stick with US government type bonds.
Are there opportunities to buy other types of bonds? Yes. But be very careful. The first step is to just know the kind of bonds that you have.
2) The Duration or Maturity
What this means is how long are you loaning money. Basically, the bonds that you own have a certain timeframe for when the company has to pay back that debt. That’s the duration or the maturity of the bond. Longer term bonds are generally considered higher risk. Shorter term bonds are shorter risk.
Look at the duration of the bond funds that you have. Is it less than two years, two to five years, or is it more than five years? Is it 10+ years? This is important for you to understand. Generally speaking, shorter duration bonds are considered less risky, so look at that.
3) Credit Quality
Imagine that you have a friend who asks to borrow some money. Actually, imagine you have two friends that want to borrow the same amount of money. One friend has a good paying job, they’ve borrowed money from you before and have always paid it back – maybe even earlier. The other friend who wants to borrow money doesn’t have a job, they’ve had jobs in the past but they’ve never been able to keep them long, and you’ve lent them money before and it’s been like pulling teeth trying to get that money back.
What I’m talking about here is credit quality. How likely is it that you’re going to get paid back. Credit quality is rated in terms of a grade, A, B, C… So, look at the type of bonds you have and look at the credit quality. Obviously, bonds that are AAA rated or AA rated are going to be less risky than bonds that are B or BB rated.
I know what many investors are doing right now. They’re looking at their overall portfolio, maybe they’ve lost some money in their stocks, and they’re looking at their bonds – especially for those people who are living on their portfolio, they withdraw money every month, and they’re paying their living expenses from the proceeds from their portfolio. The one thing that we’ve all noticed is that yields, the income that we’re getting on our bonds, is coming down. That’s because interest rates have come down. So you might be tempted to take your bonds, sell them, and try to go into other bonds or bond funds that are yielding a higher rate. That could be risky.
The problem in doing that is the bonds or bond funds that are paying more income right now are either higher yielding, maybe emerging market bond funds, maybe longer term bond funds, or of a very low credit quality. These are not characteristics of bonds or bond funds that I would suggest now – or really ever. Be very careful about switching out of short term, good quality bond funds, and into others that are paying slightly higher yields.
I get it. If you’re living on your portfolio, you want as much income as possible. But please, do not sacrifice your investment return, just because you’re trying to squeak out a little bit more income from your bond funds. Again, my philosophy is your bonds should produce income but be stable, especially in times like we’re going through right now. Don’t take extra risk in your bonds, just to try and squeak out an extra 1% or 1.5% return. That might come back to hurt you.
If you have any questions about your portfolio, the economy, or your retirement, send me a question at www.askdoctorrobert.com. I’m happy to address as many of these questions as I can. Until next time, please be safe, and I will talk to you soon.