What Job Are Bonds Supposed to Do in a Portfolio?

I recently talked with The Wall Street Journal about bonds and the role they play in a portfolio. One of the questions in the article was whether bonds should be sold.

We tend to judge investments by whether they're up or down. If they're up, they're working. If they're down, something must be wrong. I don’t think that’s always the case. You need to know why you own the investment in the first place.

Bonds are a piece of an investment portfolio, and they actually have jobs to do. They typically have one of four jobs: provide income, diversify, fund a targeted future need, or reduce volatility. The job depends on what the goal is, and bonds can have multiple jobs depending on the situation.

First, bonds are generally referred to as fixed income because you're essentially entering into a contract. This is the provide income job. You're lending money to a company, government or other entity, and the bond tells you how much you'll be paid and when. The risk associated with the bond depends in part on the financial strength of whoever is borrowing the money.

Diversification is another role bonds play. This is a basic idea of investing. Ideally, you own investments that don't all behave exactly the same way at exactly the same time. Bonds don’t automatically go up when stocks go down either. It doesn't work that perfectly. The funny thing about diversification is that when you see one part of your portfolio that's an outlier and hasn't done much for a while, a lot of times that's the thing you're thankful you own in a different market.

Sometimes bonds are useful for a very specific future event. An example might be a business owner who has a cash balance plan contribution due in 12 months. If we know how much money is going to be needed and when, we can purchase a bond that matures around that time. We know when it comes due and how much we're expecting to receive.

The same idea can apply further out. Maybe we know we'll need a certain amount of money five years from now to pay for a graduation party. The bond isn't there because we're trying to beat the stock market. It has a specific job and a date when we expect to need the money.

Bonds can also provide stability. Not every client wants or needs to stomach the volatility that comes with an all-stock portfolio. Bonds can help reduce some of that volatility and give us another part of the portfolio to work with when markets get difficult.

Should I buy individual bonds or a bond fund? I get this question a lot. There are times when owning individual bonds might make sense, especially when we're trying to match a specific future need. However, actively managed bond funds usually make more sense.

One of the things I'm paying attention to is duration, which is basically a measure of how sensitive a bond or bond fund is to changes in interest rates. Generally, a shorter-duration bond won't be affected by a change in interest rates as much as a longer-duration bond. Neither one is necessarily good or bad. An actively managed bond fund gives the manager the ability to make decisions about things like duration as conditions change. It comes back to planning for what the money is supposed to do and when you might need it.

We've lived through an interesting period for bonds. For a long time, interest rates were extremely low. Then rates moved higher very quickly, and bond prices fell. Investors who thought of bonds as the "safe" part of their portfolio, seeing their bond investments decline understandably created some questions.

What was the bond purchased to do?

If you bought a bond to provide income, is it still providing the income you expected? If you bought it to fund something three or five years from now, is it still positioned to provide that money when you need it? If you bought bonds to diversify a stock portfolio, are they still serving that role?

As I told The Wall Street Journal, "Bonds shouldn't necessarily be judged by whether they're green or red today. They should be judged by whether they're doing the job they were purchased to do."