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Why Invest in Bonds?

April 26, 2018

In the year 2017, the US Bonds’ return was just 3.54%, much lower than stock market returns. Globally, stock market returns were great in 2017: US Stocks (measured by S&P 500 Index) 21.83%, International Stocks (measured by MSCI EAFE Index) 25.03% and Emerging Market Stocks (measured by MSCI Emerging Markets) 37.28%. Bonds, they say, are a pretty boring asset class. The stock market is far more exciting. That’s where the biggest returns are found and it’s also the segment that the financial media tends to focus on.

Bonds have been out of favor for several years, with low-interest rates not seen for several decades resulting in tiny yields. Why should you invest in bonds at all?

Bonds perform two main functions in a diversified portfolio. First, and most importantly, they offset the volatility of equities. Everyone has their own capacity for risk, and it’s important that investors take as much risk as they need to take, are willing to take, and can afford to take, but no more. Bonds are far less volatile than stocks, and they often hold up reasonably well when stock markets fall. It’s a mistake to assume that bonds’ muted outlook will hamper their ability to hold up during the market downturns.

In fact, over the 20 bear markets since 1928 – measured by a decline of 20 percent or more in the S&P 500 – the average return from long-term government bonds was 5 percent, and the median return was 3.2 percent.

The second reason for investing in bonds is that they provide a source of liquidity. If, for example, if you lose your job and you suddenly need to access your money, having a decent chunk of your portfolio invested in bonds means you don’t need to sell your equity holdings at a loss.

As Nir Kaissar, a Bloomberg Gadfly columnist, recently illustrated, bonds managed to hold their ground during the seven bear markets between 1946 and 1974 when yields were low or rising. The average return was a negative 1.5%, and the median was a negative 0.3 percent. That compares with an average cumulative total return for the S&P 500 of negative 20.7 percent and a median of negative 21.8 percent.

The one exception over those 20 bear markets was that bonds returned a negative 14.6 percent from December 1968 to June 1970, compared with a negative 29.2 percent for the S&P 500. Investors who needed to access their money between those two dates would have had to sell their bonds at a loss. In each of the other 19 downturns though, they didn’t, and you have to admit 19 out of 20 is not a bad success rate.

Yields on bonds have been low for quite a while now. But so what? There are not one, but two, components to bond returns – the yield and the price. When the yield is low, the price is high, which is why when you need a relatively safe haven for your money, some government bonds are good options.

Remember, it is risk that drives returns, and we only have the capacity to take a certain amount of it. Because the stock markets are where that risk is most highly rewarded, that’s where investors should use up most of their risk budget.

So how much should I allocate to bonds and what type of bonds? The answer is “It depends”; on risk, on liquidity, on timing. Each investor’s financial situation is different so you need to work with your trusted advisor to design a customized portfolio for you based on your willingness and capacity to take risks.

In general, if your retirement timeframe is less than five years, you must pay special attention to your need to withdraw funds. This includes the timing and size of your withdrawals after you have counted your pension income and social security income. The distribution phase for these assets is very different than the accumulation phase, especially so since most people do not have pension income, and therefore most of their investments are likely to be in retirement plans such as 401(k)s and IRAs. Cash flow planning during this phase needs to work together with investment portfolio design, to determine how much to invest in low risk bonds to prepare for at least five years of withdrawals should stock markets take five years to recover from a downturn. In addition, determining which accounts to withdraw from (taxable, tax-free or tax-deferred) will affect your tax bills, so your advisor should be aware of your tax situation in order to plan ahead on buying or selling securities.

At Echo Wealth Management, first we work with clients to create a comprehensive financial plan (Echo Dashboard) that consolidates all account data in one secure location, accessible whenever desired from anywhere the internet is available. Clients can view updated financial projections, such as cash flow and balance sheet, year-by-year anytime. Creating each client’s Echo Dashboard requires gathering data so that we understand the whole picture: their financial situation, their investment goals, their cash needs, their tax brackets, their insurance needs, and their estate plan. Our approach is consultative and assists clients in determining the most appropriate level of risk for their situation, no matter what phase they are in. Once we have the whole picture in view, the next step is the selection of the underlying investments, which we then monitor, adjust, and rebalance as appropriate. We are continuously monitoring trends to find windows of opportunity for portfolio readjustments, although we trade infrequently and only when we believe it is in the best interests of our clients.

Lastly, our clients’ portfolios are designed to help our clients achieve their unique goals rather than focused on beating an arbitrary commercial index. Studies have proven that investors fail to capture the market’s return, let alone beat it, by buying and selling at the wrong time. We design client portfolios to capture the appropriate return for the level of risk taken.

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