1) Bonds can reduce portfolio risk by reducing volatility.
Creating a portfolio is like putting the pieces of a puzzle together. Portfolios are built by assembling portions of stocks, bonds, and cash. Portions of real estate and commodities may also be added. Modern portfolio theory taught us that by combining securities that don’t follow each other, when one leans left the other right, we are likely to achieve a more stable return. Bonds tend not to move in tandem with stocks. In finance terms, they have a low correlation to stocks. So if stocks drop 15%, bonds may decline but generally less or they may even rise. Bonds are the portion that may reduce short-term, gut wrenching swings in the portfolio’s value.
An example: From September 30, 2007 to March 3, 2009, the S&P 500 Index lost -53%. Barclays U.S. Aggregate Bond Index gained +7%. A portfolio with 75% allocation to stocks and 25% to bonds would have reduced the volatility of stock returns from -53% to -38%. Refer to the table below.
| Index | Investment 9/30/2007 | Value on 3/3/2009
Downside Protection |
Gain/(Loss) Volatility | Return needed to get back to initial $10,000 |
| S&P 500 Total Return * | $10,000 | $4,720 | (53%) |
112% |
| Barclays U.S. Agg Bond ** | $10,000 | $10,730 | 7% |
NA |
| 75% stock + 25% bond | $10,000 | $6,200 | (38%) |
61% |
*Source: Morningstar. Represents the U.S. stock market ** Source: Morningstar. Represents the U.S. bond market
An index is not investable. It represents the return from dividends and price changes. Past performance is not a guarantee of future returns.
2) Bonds can protect the downside.
While similar to #1, protecting the portfolio’s value is of special importance to retirees who are in the distribution phase of their life and no longer have time to recover from a large stock market decline. Extending the example from the table above, during the bear market from 2007 to 2009 $10,000 invested in the S&P 500 index would have collapsed to $4,720 whereas a 75% stock 25% bond portfolio’s value would be $6,200. To regain the initial $10,000 the stock portfolio would need to increase 112%, while the portfolio of 25% bonds would only need to gain 61%.
3) Bonds provide income.
Bonds typically pay interest, which makes up most of their return. The other portion of the return comes from the change in the price. Individual bonds typically make interest payments every 6 months. Bond funds generally distribute interest monthly. The interest payments provide stability to a portfolio, and dependable cash distributions to investors. When the markets are performing poorly, during a bear market, interest payments are a stable source of income.
The portion of a portfolio allocated to bonds varies with each individual. Items to consider include the size of their total portfolio relative to the needed withdrawals, how much time before they need to take distributions, how long they anticipate making withdrawals, and the investor’s tolerance for risk.
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