A common discussion we have with clients is about the role of bonds in a structured portfolio. At first glance, using bond income to cover cash needs and using stocks for capital growth seems like the right approach. Viewing bonds as the primary source of income, however, often leads to unanticipated risks.
At Truepoint, we believe the role of bonds is not to produce high levels of income. Generating enough income from bonds to meet current and future needs generally requires allocating a greater portion of your portfolio to riskier long-term and/or high-yield bonds. This creates a poor trade-off between portfolio risk and expected return. Long-term and high yield bonds typically add more risk to the portfolio than additional return. So the quest for yield often results in less overall return and net wealth.
When taking risk, stocks compensate risk much better than bonds. Therefore, we use lower-risk (and lower-yielding) bonds to manage portfolio-level risk and concentrate our risk taking on the equity side of the portfolio.
So where does cash needed for living expenses come from if not from bonds? Furthermore, should the source of cash flow be limited to any asset class? Whether cash comes from a dividend or capital growth, it is still money. There’s no rational reason to prefer one over the other. In the end, the source of your cash flow is less important than the level of your wealth. This is the essence of “total return” investing.
As cash needs arise, we opportunistically redeem a portion of your portfolio. This typically takes place in conjunction with portfolio rebalancing or managing taxable income. By selling shares of an asset class where its relative weight exceeds its target, we keep the portfolio allocation in-line with your long-term objective. Alternatively, when managing taxable income, where possible, we offset capital gains by selling positions to realize capital losses.
Focusing on the characteristics of the total portfolio instead of the component pieces ultimately leads to more income options without altering risk factors.
If you have any questions, please don’t hesitate to contact us. If you’re not currently a client, but would like to schedule an appointment, please contact Lisa Reynolds at (513) 792-6648 or firstname.lastname@example.org.