Ask an advisor: In this economy, do I still need bonds in my portfolio?

May 10, 2023 6:13 PM

It's been a tough year for bonds, leading one investor to wonder whether he should bother investing in them.

Welcome back to "Ask an Advisor," the advice column where real financial professionals answer questions from real people. The topic can be anything in the world of finance, from retirement to taxes to wealth management — or even advice on advising.

The U.S. government has been issuing bonds since the American Revolution. For centuries, these debt securities — essentially loans to the government, repaid with interest — have helped fund Uncle Sam and offered investors stable, conservative alternatives to stocks.

But do bonds still make sense in today's economy — which has been, to put it mildly, unusual?

For the past year and a half, Americans have simultaneously faced both a volatile stock market and record inflation. To tame prices, the Federal Reserve has raised interest rates 10 consecutive times, bringing the federal funds rate to 5 to 5.25% — its highest point since 2007.

This has been both good and bad for bonds. On one hand, the Fed's actions have sent bond interest rates soaring. For example, at the start of 2022, the yield from a six-month Treasury note was 0.22%. Today it's at 5.18%.

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On the other hand, the high interest rates have depressed bond prices. The Barclay's U.S. Aggregate Bond Index, for instance, was down 13% by the end of 2022 — its worst year on record.

All of this has left bonds in a confusing place. Do government securities still have an important role to play in investment portfolios? If stocks and bonds are suffering at the same time, can one act as a hedge against the other? One novice investor in New York is struggling with these questions and turned to our finance-savvy readers for help. Here's what he wrote:

Dear advisors,

Is there any reason for a relatively young person to allocate to bonds in this environment? If the Fed continues to hike up interest rates, bond values go down. If the Fed lowers rates, bonds go up in value but presumably the stock market will appreciate even more.

I'm a 36-year-old tech worker, and I have about $100,000 invested in index funds and $30,000 in my 401(k). I have two main goals: funding my startup, which I'm planning to launch soon, and saving for my retirement. I'd like to diversify my assets, but I'm just not seeing the advantage to investing in bonds. Am I missing something?

Thanks,

Skeptical in SoHo

And here's what financial advisors wrote back:

Different assets for different goals

Ron Strobel, a certified financial planner and the founder of

Retire Sensibly

in Meridian, Idaho

The key to answering this question lies in separating his two goals. Funding the startup in the near term is a radically different goal from retiring decades from now. I would start by identifying how much of that $130,000 is allocated to the startup and how much is allocated to retirement. Most would agree that the short-term goal money should generally be invested in safer assets like money markets, insured CDs, or even perhaps individual bonds/Treasurys. The longer-term portfolio would likely have an entirely different composition.

Think long-term ... and short-term

Noah Damsky, a chartered financial analyst and principal at

Marina Wealth Advisors

in Los Angeles

Let's look at each goal. The $100,000 to launch your start-up should be in bonds if "soon" means within the next year or two. The last thing you want is for your $100,000 to become $80,000 if the stock markets repeats in 2023 what it did in 2022. You want to be able to count on that money being there, so a money market fund, short-term bonds or CDs might be a fit, as they can offer annual returns of over 4%, plus liquidity.

Your retirement account may not need to have bonds. Technically, having some bonds offers a better risk-adjusted return than all stocks. However, with a time horizon of over 20 years until retirement age begins, you can realistically ride an all-stock portfolio for years before you begin to add bonds as retirement nears.

The fact that you're carefully considering your options means you're on the right track. Way to go!

The beauty of bonds

Tara Unverzagt, a certified financial planner and the president of

South Bay Financial Partners

in Torrance, California

This is a perfect example of when bonds work beautifully! Yes, bonds help with diversification, and even if you're looking at a retirement account that's targeted for 30 years down the road, a little investment in bonds helps with the downside risk of the stock market.

For this person, who needs funds soon to start his business, those funds should not be in the stock market. He may find, right when he wants to start his business, the stock market is down 20%. He would have to have a fire sale of stocks to start his business with that money.

Instead, he could set up a bond ladder to have that money get a guaranteed 4.5%-5% return in the bond market and have cash available exactly when he wants it. If he's starting his business in three years and he thinks he's going to need $50,000 per year for the first five years to get it started, he can have a $50,000 bond mature at the beginning in three years. That bond matures, giving him $50,000 of liquidity to pay his bills when he starts his business.

He would have four more bonds due for each of the next four years after opening the business. The beauty of bonds is you know you will get the money back when it matures (as long as the company or the Fed doesn't go bankrupt before then).

He would probably also want a $50,000 contingency in a money market that is also currently making 4.5% for any unexpected expenses that come up while he gets his business started. The money market is liquid. He can access that money overnight, and the value doesn't go up and down as a stock or bond does.

Don't get spooked

Amanda Vaught, a financial advisor and the co-founder of

Propel Financial Advisors

in Maryville, Tennessee

No, you do not have to use bonds in your portfolio. For those with a high risk tolerance and a long time horizon, an investor can get better returns using stocks alone.

For funding Skeptical's start-up, a short-term goal, I would not recommend an equity-only portfolio. Just like you can't time the stock market, you also can't time the bond market.

Yes, many commentators think the Fed may lower rates soon, but many also say that the Fed will keep rates higher for longer. Don't get distracted by the shiny object that is short-term interest rates. Avoid the perils of reinvestment risk and lock in some of those higher rates with a longer duration bond than a three- or six-month T-bill.

The mechanics of the bond market can be more complicated for retail investors than the stock market. Don't let this opaqueness stop you from investing in a valuable asset class.

For Skeptical, an equity-only portfolio for his retirement could be appropriate, as long as he doesn't get spooked by the volatile swings that can occur. The bond side of a portfolio can provide important ballast to a portfolio and protect against an investors' worst instincts taking over in a downturn.

Focus on what you can control

Travis Gatzemeier, a certified financial planner and the founder of

Kinetix Financial Planning

in Flower Mound, Texas

For young professionals in the accumulation stage, the need for bonds is very minimal in long-term investing accounts. Rather than focusing on the things you can't control, such as what's happening in the environment, it's important to remember what you can control: your asset allocation and behavior.

To determine if you need any bonds and what kind, your accounts should have a purpose and a timeline. For example, if your 401(k) is money for 20-plus years from now, you have a time horizon for an aggressive allocation with little need for any bonds.

Historically, equities give you the highest potential for long-term returns. Bonds could drag down those returns in exchange for some stability. However, stability can come from your other accounts that aren't for 20 years down the line, such as your cash reserve and brokerage accounts.

If you plan to launch your startup soon, you need access to the money immediately. Unless you have saved this in cash already, it shouldn't be invested in equities. The reason is that if your $100,000 was earmarked as startup money, and the market drops by 30% before you launch, you may have to delay the goal, or not be able to launch. The short-term potential return isn't worth the risk in this situation.

As for the type of bonds, I believe in using quality bonds like U.S. Treasurys or U.S. Treasury funds. This is because Treasurys provide the most stability when you actually need it.

Corporate bonds and high-yield bonds can act much like equities during market chaos. In other words, when you want stability, you don't get it with corporate and high-yield bonds. So you end up taking an equity-like risk without equity-like returns. This is why I believe in owning Treasury fixed-income positions for stability if needed and taking long-term risk in equities.