Bonds???

Yes, our team has been asked this question more than a couple of times over the last few months. Why hold bonds now?

The main critique of bonds today goes something like this:

• Bonds are in the Preservation Bucket in my portfolio for stability.
• The value of my Preservation Bucket is not stable.
• Therefore, bonds are not serving their purpose.

There is no doubt that bonds are in an historically difficult season from a price perspective.  Inflation pressures have forced short-term interest rates up at a rapid rate, and prices have fallen commensurately to accommodate for the higher yields of newly issued bonds. The missing consideration in the above logic is the time component for a fixed income portfolio. Much like the stock market, we ought not measure the “stability function” of bonds within a portfolio on too short of a time frame; else, we set ourselves up for faulty decision making.  So, what is an appropriate time frame over which to measure the effectiveness of “stability?”

Bond investors utilize a mathematical formula that calculates the “duration” of a bond or portfolio of bonds.  The “duration” of a bond simply measures the time until an investor recoups his or her full investment. The duration of the bond portfolio sets the target for the time frame over which stability ought to be measured.

Thus, when measured against the appropriate time periods, the stability of a bond or portfolio of bonds is defined more by credit quality and less by moves in interest rates – since bond investors benefit from higher yields when prices decline and an investor’s return at maturity is a known quantity.

With this understanding, the primary and secondary considerations for investors relating to their bond portfolio should be:

1. Does the calculated duration of my bond portfolio match my time need for stability?
2. Does the credit risk in my bond portfolio represent my need for stability over the appropriate time frames?

If the duration of my bonds matches my needs, and my credit risk is appropriate, then even rising rate environments the likes of which we are experiencing today can be experienced with the confidence that bonds can continue to fulfill a critical role in a well-managed portfolio.