June 28, 2014

Why we own Bonds

“Three statisticians go hunting. When they see a rabbit the first one shoots, missing it on the left. The second one shoots and misses it on the right. The Third one shouts “We've hit it!”
                                                                                                            (Math joke)
  
As an investor in bonds I'm always curious as to the future path of interest rates, especially when the Federal Reserve is busy talking about it in the media. But when economists and the business community alike go hunting for evidence to that fact they have a benefit, much like our hapless statisticians above, which is they can afford to be "in line with their expectations"  (i.e. wrong) since forecasting of any kind is inconclusive. So, what do I do in the meantime? Well we own bonds anyway, and here's why.

Everyone knows that the cash they hold in their checking, savings or investment accounts is earning a yield that approaches 0%. I've written a few times over the years, mostly since the financial crisis, that condition has been the recipient of passive Fed policy.  And I'm not about to report differently today. Rather I want to discuss ways to take advantage of the current environment and the benefits of bonds, not solely as a source of income, but as an investment that reduces the risk in a portfolio dominated by stocks.

There are two ways to invest in bonds that are most widely used and which and my clients are familiar with*. The first is through individual bonds.  An individual bond is an asset that has a "coupon" that determines the amount of income an investor receives, and a "maturity", an end date, that informs the investor how long the income can be expected for.  At maturity a predetermined amount of the original investment will be returned, which is what make them unique from stocks.

The other method of investing in bonds is through a Mutual Fund, which can be expressed as a basket of individual bonds similar to those described above. This type of asset is managed by a portfolio manager who invests in bonds according to a benchmark, which is a guideline that allows for easier analysis of the fund performance.  Similar to a mutual fund is an asset I use called an ETF (Exchange Traded Fund). Other than different procedures for buying and selling, ETF's have many of the characteristics of a mutual fund with much lower costs. Most are structured like a popular benchmark (indexed) and some are managed by a portfolio manager (active).

Most of the types of bonds that I generally invest in are US Treasuries and Municipal Bonds, mostly for the lower risk and because the income carries some tax benefit, and Corporate Bonds that are issued by corporations with strong credit ratings and names that the public is generally familiar with such as General Electric (GE) and Oracle (ORCL). Customarily the risk I look for is modest because I don't use bonds to compete with stocks. This is because I believe stocks are for growth in a portfolio and bonds are for the stability.

Complicated? Sure, but the benefits of the different ways to invest in bonds are obscured by too much public debate on the merits of preserving the stock market and the appearance of endless disregard the Fed seems to have for keeping rates so low, especially at the expense of people dependent upon a fixed income. In the end all accounts will have exposure to this very important asset class and my focus will be on reinvesting the income to compound what little income exists and remain nimble to the inevitability of higher interest rates before the Fed decides the economy warrants it.