The Effect of Bonds on Risk and Return

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If you go to an investment advisor or read advice in a finance magazine, they will usually recommend a stock/bond mix.  The advice used to be to have a percentage of bonds equal to your age.  For example, a twenty year-old should have 20% bonds and 80% stocks, while a 60-year old should have 60% bonds and 40% stocks.  The advice has changed somewhat as people are living longer and retiring later, with perhaps a 10% reduction in the percentage of bonds.  A 60 year-old now might hold 50% bonds, for example.

The term “bonds” is somewhat of a misnomer.  When one hears “bonds” one thinks of some safe investment like a bank CD.  Buying individual bonds can, however, be quite risky.  When buying a bond, you are giving a loan to a company.  If the company runs into financial troubles, they may default on the bonds.  When that happens, you will be lucky to get $30 from the company for a $1000 loan.  I have had it happen many times.

Instead of saying one should invest in “bonds,” the advice should be to invest in income-producing assets.  Income-producing assets are those where the investor expects to make money primarily from dividends and interest payments from the asset.  These types of assets provide more safety than growth instruments – those from which one make money because the price of the asset increases – because the amount of income paid per month, quarter, or year tends to be fairly repeatable, meaning that it is easier to predict how much return the asset will produce.  For example, if a bond pay $100 per year in interest payments, and the cost of the bond is $1000, one could expect about a 10% return from the bond.  I say “about 10%” since the price of the bond can change.  If the bond pays $1000 in interest but the price drops from $1000 to $900 over the year, the total return would be nothing.

Another reason that income-producing assets are safer than those that don’t pay a dividend is that their interest and dividend payments tend to support the price of the asset.  For example, with the bond I mentioned paying $100 per year, if the price dropped to $500, the interest paid would then be 20% per year.  Because the average return for stocks is somewhere between 10 and 15%, a bond that is paying 20% would be very attractive.  This means that it is unless the company was likely to default on the loan or stop paying the interest payments for some reason, it is unlikely that the price of the bond would fall much further.  Also, because the full loan amount is eventually repaid at some preset date as specified in the details of the loan, one could expect to eventually receive the full $1000 for the bond if one continued to hold onto it.

Other types of assets produce income but don’t have an expiration date at which the buyer is paid a set amount, which makes them a little more risky.  For example, preferred shares of stock tend to pay good yields, of 5-10% or more, but they continue indefinitely.  This means the asset may never again sell for the price one paid no matter how long one holds onto it.  Just as with bonds, however, the price tends to be supported by the yield in that if the price drops enough the high yield brings in buyers.

Other income-producing assets include large company common stocks – companies who have grown so large that they pay out most of their earnings in dividends – Real Estate Investment Trusts (REITS), which are essentially mutual funds of real estate properties, and Limited Partnerships.  Limited Partnerships are partnerships that trade like common stocks except that one is buying a direct interest in a company.  Owners of limited partnerships split the profits but must also list income and losses on their individual tax returns (the best strategy is to buy these in an IRA account to save the tax hassle).

The effect of income-producing assets is to smooth out some of the fluctuations in the value of the portfolio.  Income-producing assets tend to have a lower return than growth assets, but they also tend to decline less than growth assets during downturns.  This means that one might only average a 12% return instead of a 15% return by investing 20-30% of the portfolio in income-producing assets instead of holding all growth stocks, but the fluctuations in portfolio value will be less severe.  For those who don’t like to see the value of their portfolio drop by 30% in a bear market, adding some income-producing assets can bring some comfort.  In addition, in times like the last decade where returns from stocks were essentially flat, the income from dividends and interest payments can provide some gain for the portfolio.

In summary, income-producing assets reduce possible return somewhat but also reduce risk.  As one gets closer to needing the money and cannot afford to wait 5-10 years after a big drop for asset values to recover, adding income-producing assets can provide some stability.  Keep in mind, however, that the support provided by income-producing assets is only as good as the security of the asset stream.  If a company that pays a big dividend runs into troubles with their business and no longer generates enough income from which to pay the dividend, the dividend will be cut and the price of the stock will likely fall.  As with growth, diversification should be used to cut risk when one cannot withstand a financial loss.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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