Understanding Bonds and Their Purpose in a Portfolio
Bonds play a vital role in building a well-balanced investment portfolio. Though bonds may lack the excitement of stocks, they offer reliable income and help manage risk. Whether you’re planning for retirement, saving for a major purchase, or looking to grow your wealth steadily, bonds can add stability and balance to your portfolio.
Let’s look at the ways bonds work alongside other investments to create a stronger, more resilient portfolio that supports your financial goals.
Bonds explained
At its core, a bond is a loan to a government or business. Bonds have a set term and mature on a specific date. Over this period, the bondholder receives regular interest payments, and the original loan amount (principal) is repaid at maturity.
Since a bond represents a loan rather than an ownership stake, bondholders don’t benefit from a company’s profits or growth. Instead, bondholders are entitled to fixed interest payments, which take priority over payments to shareholders. This structure helps explain why bonds tend to be less volatile than stocks and can provide stability during periods of market turbulence.
Why have bonds in your portfolio?
Bonds play a key role in a diversified portfolio by helping balance risk and return. Bonds provide valuable diversification benefits by behaving differently from stocks across various market cycles. While stocks are generally more volatile and sensitive to economic growth and corporate earnings, bonds—particularly high-quality government and investment-grade bonds—tend to be more stable and less correlated with the stock market.
This low or negative correlation means that when stock prices decline, bonds (usually) act as a stabilizing force, helping to cushion the overall portfolio against severe losses. This is especially important to investors who take regular withdrawals; if the stock market is down while bonds are holding up, cash can be raised from bonds, to avoid selling stocks at relative lows.
Additionally, the reduction in volatility from including bonds can improve a portfolio’s risk-adjusted returns. By blending asset classes with different characteristics, investors can reduce overall risk without proportionally reducing expected returns over extended time periods.
Pursuing higher expected returns requires more risk taking
The strong link between risk and return appears in all properly functioning capital markets. When investing in stocks, bonds, or other assets, investors must accept more risk to pursue a higher potential return. In the bond market, earning a return above short-term government rates typically means taking on interest rate and/or credit risk. Interest rate risk refers to a bond’s sensitivity to interest rate movements, and credit risk refers to the default potential of the borrower.
Interest rate risk
Longer-term bonds are more sensitive to interest rate changes—when rates rise, bond prices fall, and vice versa. The longer the time to maturity, the more a bond’s price will move in response to rate changes, often requiring a higher yield to compensate for the added risk.
Research shows the bond market is efficient, meaning short-term prices and interest rates can’t be reliably predicted; prices already reflect expectations, which can shift quickly with new, unknowable information. Because no one can consistently forecast interest changes, investors should avoid making bond decisions (short- or long-term bonds; low- or high-quality bonds) based on predictions, media, or gut feelings.
Credit risk
In terms of credit risk, the government is generally considered the strongest borrower in the market, so it has a lower cost of capital (yield) compared to other bond issuers. The most creditworthy companies are considered relatively safe, but they still must offer a higher yield than the government to compensate investors for taking more default risk. The weaker a corporate borrower’s financial condition, the more it must pay in interest to attract investors. Investors seeking higher returns on the credit spectrum must bear a higher risk of default.
Our investment team monitors the credit quality and interest rate risk of our bond portfolio to ensure the return justifies the risk being taken.
Bonds provide stability and balance in the portfolio
At Truepoint, we believe risk shouldn’t be taken with bonds, so we invest in high-quality bonds that provide stability and balance out the volatility of stocks. While increasing the term or decreasing credit quality could produce higher returns, it comes with higher risk. Instead, risk is taken with the stock allocation, which provides a premium above bond returns over the long-term. Our team ensures that your asset allocation—the balance between stocks and bonds—aligns with your goals and gives your financial plan the greatest chance of success.
