Where bonds still make sense

When you own a bond that pays a fixed interest rate of 3%, your investment becomes a lot more valuable when market rates fall to 1%. Conversely when rates climb to 5%, your 3% bond looks a lot less attractive. Does that make sense?

If so, you now understand the simple but key relationship between interest rates and bond prices: falling rates make prices rise, and rising rates make bond prices fall. So, with the Fed now aggressively raising interest rates to combat inflation, is there still any reason to own bonds in your portfolio?

If you’re looking purely for capital appreciation, fixed-income investments will likely disappoint you for the foreseeable future. And even in the longer term, bonds have historically underperformed stocks by a wide margin on a total return basis, especially net of inflation.

But I can think of four other circumstances where maintaining some allocation to fixed-income investments is justifiable, even in today’s very challenging environment:

1. You want more stability. If you are retired and systematically making portfolio withdrawals to supplement Social Security and pension income, market volatility can exacerbate what’s known as sequence-of-returns risk. Adding fixed-income investments can help tamp down volatility and add stability, which reduces that specific risk.

2. You need income. Rising interest rates mean new bonds are being issued with higher payouts. Using the bond ladder strategy allows you to systematically roll over maturing bonds at those higher rates and increase the income your portfolio generates. This approach also offers a different set of benefits when interest rates are stable or falling.

3. You like the idea of buying low and selling high. Periodically rebalancing your portfolio involves selling investments that have outperformed, then using the proceeds to purchase others that haven’t yet had their day in the sun. Having a set allocation to bonds can provide the cash you’ll need to buy stocks when they’re on sale, and vice versa.

4. You have definite future spending needs. My favorite use for fixed-income is to “escrow” funds to cover expenditures you know you’ll have in the short to intermediate future, say, within the next five or ten years. Our grandson Michael will start college in 2027, for example, so we want most of the money we’re investing for him to be in something with more historically reliable returns than equities. We are willing to trade away some upside potential in return for a greater probability the money will be there when he needs it. By contrast, our granddaughter Cece starts college in 2035. With a time horizon that long, equities probably make more sense, but we will adjust the mix toward fixed-income as college gets closer. And here’s hoping they both get scholarships!

When it comes to building wealth, bonds and similar fixed-income investments leave a lot to be desired. But when your primary goal is preserving wealth or paying for future expenditures, they can play a vital role in your portfolio, even in a rising-rate environment.

In the meantime, you can improve your chances of success by focusing on bonds with relatively short maturities (at least until interest rates stabilize at higher levels), keeping your fixed-income portfolio diversified, and utilizing bond ladders or similar strategies.

Any opinions are those of Brown Family Wealth Advisors and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. The information does not purport to be a complete description of the securities, markets, or developments referred to in this material. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Past performance may not be indicative of future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Prior to making an investment decision, please consult with your financial advisor about your individual situation.