The Role Of Bonds In A Portfolio
Episode 194
Episode Guide
Episode Timestamps
ChooseFI Podcast Episode Show Notes
Episode Summary:
This episode discusses recent guidance from the SBA regarding the Paycheck Protection Program (PPP) and its implications for self-employed individuals. The hosts, Jonathan Mendonsa and Brad Barrett, along with community expert Frank, explore the role of bonds in an investment portfolio, focusing on stability, income, and diversification.
Key Topics:
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SBA Guidance on PPP
- The U.S. Small Business Administration provided important updates about the PPP.
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Bonds in Investment Portfolio
- Community inquiry regarding bond inclusion in investment portfolios for those nearing retirement.
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Ask Frank Segment Introduction
- Introduction of Frank, a community expert, who shares his expertise on bonds.
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Frank's Experience during 2008
- Frank recounts lessons learned from the bond market during the financial crisis.
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Purpose of Bonds
- Overview of the three main purposes of bonds: stability, income, and diversification.
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Long-term Treasuries Discussion
- Discussion on the advantages of holding long-term treasury bonds in unstable markets.
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Diversification Strategies
- Strategies on how to effectively diversify bond holdings to manage risk.
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Portfolio Management Advice
- Insights into effective portfolio management practices and avoiding impulsive decisions based on market fluctuations.
Key Quotes:
- "A 60/40 stocks to bonds allocation can smooth your investment ride during volatile times."
- "Frank's insightful comments are worth saving—they stand the test of time."
- "Bonds offer greater diversity than stocks, which is crucial for effective portfolio management."
- "Aim for a diversified portfolio to avoid high correlation in bad market conditions."
- "Investing in bonds is easy through Treasury Direct."
Actionable Takeaways:
- Use your 2019 Schedule C for PPP loan calculations if you are self-employed.
- Diversify bonds in your portfolio for better risk management.
- Utilize tools like Portfolio Charts to analyze your investment diversification.
Resources:
- Portfolio Charts - Tool for evaluating and simulating portfolios.
- Portfolio Visualizer - Tool for complete portfolio analysis and correlation studies.
Discussion Questions:
- How can bonds add value to an investment portfolio?
- What lessons did Frank learn from the 2008 financial crisis?
- What strategies are effective for diversifying funds in a portfolio?
- What tools are recommended for evaluating investment performance?
- How do different types of bonds behave in volatile markets?
Listen to this episode for valuable insights on portfolio management and how bonds can play a critical role in achieving financial independence.
Navigate Market Volatility with Bonds: A Guide to Portfolio Stability
Achieving financial independence requires strategic planning, especially when it comes to handling investments. Incorporating bonds into your investment portfolio is a vital step in maintaining stability during unpredictable market conditions. This article draws insights from the insights shared in the ChooseFI podcast episode featuring Speaker, discussing bonds' role, diversification strategies, and actionable advice for investors.
Understanding the Role of Bonds
Bonds serve multiple functions within an investment portfolio, including:
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Stability: Bonds typically offer a more stable investment than stocks, making them essential during volatile market conditions. A balanced 60/40 allocation of stocks and bonds can indeed smooth out investment fluctuations, helping you maintain a more stable investment experience.
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Income Generation: Bonds can provide a consistent stream of income through interest payments, which can be useful for those approaching retirement or looking for regular cash flow.
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Diversification: Bonds can diversify your portfolio, especially if you hold different types that react differently to market movements. For instance, long-term treasury bonds often perform well in economic downturns, counteracting potential losses in stock investments.
How to Diversify Within Bonds
While bonds inherently offer lower volatility than stocks, not all bonds are created equal. To create a robust portfolio, consider integrating various types of bonds:
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Treasury Bonds: U.S. government-issued bonds are generally stable and considered low-risk. They can increase in value (capital appreciation) when market interest rates fall.
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Corporate Bonds: Issued by companies, these bonds can provide higher yields compared to government bonds but carry more risk. Understanding the credit quality of corporate bonds is essential, as higher yielding often correlates with higher risk.
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Municipal Bonds: These are tax-exempt debt securities issued by states, cities, or counties and typically offer lower yields but are suitable for investors in higher tax brackets.
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TIPS (Treasury Inflation-Protected Securities): These bonds are designed to protect against inflation, making them a smart choice for preserving purchasing power.
Implementing a Smart Bond Strategy
To incorporate bonds effectively in your investment strategy, follow these key steps:
Review Your Current Holdings
Evaluate your current bond portfolio. If you primarily own a total bond fund, such as Vanguard's BND, consider if it aligns with your goals for stability, income, and diversification. While BND provides some measure of stability, diversifying further could enhance your portfolio.
Use Tools for Evaluation
Utilize resources like Portfolio Charts and Portfolio Visualizer to assess your portfolio's historical performance and make informed decisions regarding your bond investments. These tools can help gauge asset correlations and optimize your allocation for better diversification.
Avoid the Urge to Chase Returns
Maintaining a consistent investment strategy is crucial. Resist the temptation to buy bonds based on short-term performance trends. Instead, focus on the long-term stability and balance of your portfolio, ensuring it aligns with your overall financial goals.
Incorporating Bonds for Self-Employed Individuals
If you are self-employed, recent updates from the Paycheck Protection Program (PPP) allow you to calculate loan amounts based on your previous Schedule C income. Use these funds wisely, potentially allocating part of them toward a bond portfolio to ensure greater stability during economic uncertainties.
Monitoring Market Conditions
Keep an eye on economic indicators that impact bond performance. For instance, during market downturns, long-term treasury bonds tend to appreciate, making them a valuable hedge against stock market losses. Understanding these market behaviors will allow you to strategically adjust your allocations as needed.
Conclusion
Integrating bonds into your investment strategy is essential for achieving financial independence and stabilizing your portfolio. By diversifying your bond holdings, utilizing assessment tools, and maintaining a disciplined investment approach, you can navigate market volatility while ensuring your financial goals remain within reach. Remember to continuously educate yourself and adapt your strategy as the market evolves, all while avoiding the pitfalls of chasing short-term returns. Embrace the journey toward financial independence by ensuring your investment portfolio is structured for resilience against economic fluctuations.
What if you don't want to be 100% equities in your portfolio? What role do bonds play in your portfolio?
[elementor-template id="143609"]Frank is an active member of the ChooseFI community and has a lot of knowledge in this area. In 2008, read "Spend To The End" that said he should put all of bond money in TIPS (Treasury Inflation Protected Securities). He thought they would do well while stocks were doing poorly... but the reality was his TIPS went down too!
So he started wondering, are there bonds that actually do go up when the stock market goes down? He found that the world of bonds is extremely varied, just as varied as the stock market.
There are three purposes of bonds in your portfolio:
- Stability
- Income
- Diversification
Stock Vs Bonds
Stocks are a piece of ownership of the company. Bonds are debt. When you buy a bond, you are loaning money to the company or government. A bond has a length just as a loan does, this can vary from 30 days up to 30 years.
You can buy government bonds directly from the government at treasurydirect.gov. But it probably makes more sense to buy bond funds. For example, the Vanguard Total Bond Fund (BND).
The Vanguard Total Bond Fund includes:
- 50% treasury bonds which are bonds issued by the federal government
- 25% in high grade corporate bonds which are issued by the largest most stable companies
- 22% are government mortgage bonds. These are the bonds that are used to back mortgages
- 0% municipal bonds
- 0% junk bonds which are low grad corporate bonds
Bond terms in the Vanguard Total Bond Fund:
- 36% of the bonds are long term bonds which are 10 years or more
- 39% are intermediate term which are 5-10 year terms
- 25% are short term
Listen: Stay The Course
Bond Returns
There are two components of return from bonds--one is the interest you receive and the other is appreciation or depreciation--they can go up and down in value. Generally, when interest rates fall, the capital value of your bonds rises and vice versa.
The reason your bond becomes more valuable when rates fall is because the bonds that have already been issued are at a higher than current market rates. For example, if a bond is issued with a fixed rate of 5% and then rates fall to 4%, that 5% bond is more desirable.
You may think that bond funds do not track the stock market, but that isn't necessarily the case. The Vanguard Total Bond Fund fell along with the stock market in early March of this year and then recovered. The reason for this is because corporate bonds tend to follow the stock market. When corporations show signs of trouble, it makes sense that the perceived likelihood of them defaulting on their debt (their bonds) would increase--making their bonds less valuable.
However, government bonds go the opposite of the stock market. If corporations can't be trusted to pay their debts, those government bonds start looking pretty good.
Another factor that is important in how much a bond fund will move is the duration of the bonds. Longer term bonds will have more volatility.
Bonds That Rise When The Stock Market Falls
The Vanguard Total Bond Fund is stable. Due to it's mix of issuers and terms it doesn't track the stock market at all. It has a 0% correlation to the stock market. However, there are bonds that will do the opposite of the stock market. Bond funds that rise when the stock market falls.
Long Term Treasury Bonds
The most common fund for Long Term Treasury Bonds is TLT. Frank also invests in EDV. Both are bond EFTs.
The interest rates on these funds is small, 3 or 4% but the capital appreciation when the stock market is volatile is why Frank invests in them. They can be quite volatile themselves, these are not funds he uses for stability. When interest rates drops 1 or 2% the capital appreciation of these bond funds might raise 20 or 25%. But it works the other way too! When interest rates rise, the value of these bond funds will drop dramatically.
So how do funds with such high volatility create balance? Since these funds move in the opposite direction of the stock market it brings balance to your portfolio as a whole. But you want to be cautious not to weight too heavily to one side or the other.
Listen: Investor Policy Statement
Tools
There are tools out there that allow you to run simulations and you can see how different portfolio mixes would have performed in different historical time periods.
Check out M1 Finance if you are interested in a fee-free robo advisor.
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