Bonds. Boring, right? Well, as I have written in previous newsletters, they play a pivotal role in your portfolio.
“First of all, what are bonds?” you ask. Not a dumb question. I would say most people don’t understand how bonds work. Think of it like this. With a stock, you own a piece of a company until you sell it and, with a bond, you lend to a company and they can pay you back over time. If the company fails, bondholders (e.g., lenders) typically are paid back first and stockholders (e.g., owners) usually are paid back last, if at all.
Thus, bonds are less risky than stocks and they act as a risk reducer in your portfolio. Historically, when stocks have been down, bonds have been up. What happened in 2008 is a perfect example: the S&P 500 was down a whopping 38 percent; however, bonds were up five percent.
Furthermore, bonds help mitigate the additional volatility that international, value and small companies add to the portfolio.
At the same time, they can provide a good return. For the past 20 years, bonds have returned over eight percent per year. Yes, eight percent per year. In fact, over the past 30 years, bonds outperformed stocks. This is rare and has only happened one other time in history. It’s also part of the reason bond return expectations look bleak over the next 10 years or so.
So what’s the concern? The issue is that everyone knows you need bonds as insurance against a large drop off in stock prices. However, the yields – or expected returns – on bonds have dropped so low it’s concerning investment managers that performance may lag, especially for their clients with bond-heavy portfolios. There is even a lot of talk about moving out of bonds and into dividend stocks. “Search for yield” is the latest moniker in today’s press regarding this conundrum. How does one find higher-yielding investments when the Fed is forcing bonds, CDs and money markets to provide very low income streams?
First and foremost, Redwood believes you should focus on the total return of your portfolio. Bonds, like all the investments in your portfolio, play a role much like each musical instrument in a symphony orchestra. Every instrument is unique and works together to create a symphony masterpiece. Therefore, the symphony – not an instrument in isolation – should be the focus.
With bonds, we think they’ll continue to play a key role in your portfolio (e.g., the symphony masterpiece) and, consequently, we don’t advise taking them out completely. Moreover, if you move any money out of bonds, you are, hands down, taking on more risk. Especially when you move that money into stocks – dividend-paying or high-growth, non-dividend paying.
With that said, we continually discuss this situation in Redwood’s investment committee meetings and are keeping a close eye on the situation. In addition, we believe this may be an opportunity to take on slightly more risk considering bond returns may have a significant drag on portfolios going forward. One potential scenario involves taking a small bit from bonds and adding more to the Alternative Investment portfolio. Alternative Investment assets offer higher income with slightly less risk than investing in stocks. It still takes more risk, but not as much as buying stocks. However, this approach, of course, depends on each client’s goals and risk tolerance.
Moreover, the bonds we keep in the portfolio will be top-rated, investment-grade, corporate- and government-backed bonds, while at the same time using bonds that mature within the next five years to protect against a large interest rate move. Here at Redwood, we retain a keen focus on our bond portfolios and ensure this piece is top notch so, when the stock market drops, you know the bond portion of your portfolio will be there.
As always, all our funds – whether they are stock, bonds or an obscure alternative – are thoroughly vetted whereby I leverage my expertise from the institutional world and can assure you I know exactly what all our mutual fund managers are holding.
Lane Steinberger MBA, CFA, CFP®
Partner, Chief Investment Officer