Bonds are less vulnerable to volatility than stocks
Published in the April 16 – 29, 2014 issue of Morgan Hill Life
By Dan Newquist
Dan Newquist
Market volatility returned briefly in the first quarter of 2014 on worries about softer economic numbers due to uncommonly harsh weather and geopolitical conflicts in Ukraine and Venezuela. While every period of market volatility and decline can be uncomfortable, a well-balanced portfolio can help weather you through.
All investments offer a balance between risk and potential return. The risk is the chance you will lose some or all the money you invest. The return is the money you stand to make. The balance between risk and return varies by the type of investment, the state of the economy and the securities and bond markets. To earn the higher returns, you have to take greater risk.
No matter what your risk tolerance, bonds play an important role in a well thought out asset allocation strategy. An allocation of cash alternative and bonds will dampen the overall volatility and risk in your portfolio.
So, what is a bond? A bond is a debt security in which you are lending money to the issuer. In return for lending the money, the issuer promises to pay a specific interest rate during the life of the bond. The issuer will repay the principal, the amount invested, when the bond matures.
Common types of bonds available for investment include U.S. government securities, municipal bonds, corporate bonds, mortgage backed or asset-back bonds, and international bonds.
Bonds in general are considered less risky than stocks for several reasons:
• Bonds carry the promise of their issuer to return the face value of the security to the holder at maturity; stocks have no such promise from their issuer.
• Most bonds pay investors a fixed rate of interest income that is also backed by the issuer. Stocks sometimes pay dividends, but their issuer has no obligation to make these payments to shareholders.
• Historically the bond market has been less vulnerable to price swings or volatility than the stock market.
As interest rates change, so do the values of all bonds in the marketplace. If you are thinking about buying bonds, you need to be aware of the effect of rising interest rates. As interest rates go up the price of your bond will go down.
You can also buy bonds through mutual funds or exchange-traded funds. Depending on your circumstances, funds may provide greater diversification at a lower cost than individual bonds. However, a bond fund has no specific maturity date and therefore behaves differently from an individual bond, though like an individual bond, its price typically moves in the opposite direction from interest rates.
Another important consideration is your tax bracket. Should you invest in tax-free bonds or taxable bonds? The interest from government or municipal bonds are tax free, either state or federal or both. Depending on your income tax situation, you may decide to invest in taxable or non-taxable bonds, or a combination. Consult with your investment or tax advisor about your situation.
If your risk tolerance is very low, CD’s can be part of your fixed income. But with current interest rates so low the interest you receive from them most likely won’t be enough to pay your expenses.
An analysis of your needs, investment objective and risk tolerance will reveal how your portfolio should be allocated. Risk exists in both stocks and bonds. Working with you investment advisor will help guide you to an appropriate allocation to suit your risk tolerance, investment and income objectives.
This article is for educational purposes only and is not intended as tax, legal or investment advice.
Dan Newquist, CFP®, AIF® is a Principal Investment Advisor Representative with RNP Advisory Services, Inc., a registered investment advisor, in Morgan Hill. He can be reached at 408-779-0699 or [email protected]. Securities offered through Foothill Securities, Inc., member FINRA/SIPC, an unaffiliated company.
