By Andy Willms, President & CEO
Individual bonds and bond funds have long been considered an essential component of a diversified investment portfolio. But with interest rates at an all-time low, and the weakened economy raising the risk of default, some are asking if bonds still belong in their portfolio.
There are three primary reasons why bonds have long been considered a core component of a diversified portfolio.
Bonds as a source of income
One of the main reasons for investing in bonds has been that owning fixed-income has been a good source of income. However, that has not been the case for some time now.
A decade ago, the yield on the 10-year Treasury was 3.8%. Ten years before that it was 6.4%. At the time of this writing, the yield on a 10-year Treasury Note has been ranging between 0.60 and 0.70%. That’s not enough to keep pace with inflation, much less provide cash to live on.
In an effort to earn a higher yield, some investors have turned to longer dated maturities, which usually generate higher yields than shorter term bonds. However, in today’s market the reward is minimal for assuming a greater risk associated with longer-maturity bonds. As I write this, the yield on a 30-year Treasury is a smidgen over 1%.
Another way to get more yield is to buy bonds from issuers with lower credit ratings. The yield available from these issuers is higher because there is a higher (and in some cases significantly higher) risk of default. However, this undermines the second main reason for buying bonds – safety.
Bonds as a safe haven
Historically, the second reason for investing in bonds is that, as a general rule, they are considered a safer investment than stocks. That’s not to say that bonds are risk-free. To the contrary, there are two primary risks associated with investing in bonds.
Default Risk. While common stocks come with no guarantees, bond investors are entitled to receive their investment back when the bond matures, provided the issuer does not go bankrupt. Since it is virtually impossible for the U.S. government to default, Treasury bonds are considered to be the safest investment.
Municipal bonds are considered somewhat less safe than Treasuries, but muni defaults have been few and far between. Further down the fixed-income safety scale: corporate bonds, which rely on the ability of the issuer to repay their debts. Corporate debt carries more risk than Treasuries and munis but are generally safer than stocks because most bond holders have priority over stockholders in the event of bankruptcy.
Interest rate risk. This is the risk that the market value of a bond will decline if rates rise. This risk is considerable at the present time, given that interest rates are at or near an all-time low. Moreover, Treasuries and municipal bonds are not shielded from this risk.
The diversification benefit of buying bonds
A third reason for owning bonds is that they provide stability to a portfolio by acting as a counterweight to the stock market’s volatility. That’s because most of the time, bonds will outperform stocks during bear markets. This is especially true for U.S. Treasury bonds, as well as bonds with a shorter term.
While a bond’s ability to provide income and safety has declined recently, the diversification benefit associated with bonds continues. To me, it remains the single most important reason for continuing to invest in bonds.
The case for avoiding bonds altogether
While bonds are still considered an essential element of a diversified portfolio for most investors, a case can be made for excluding bonds altogether. That is especially true for investors who are committed to investing in stocks for ten years or more, and who are either able to tolerate wild swings in the value of their portfolio, or tend to pay little attention to what their investments are worth. That’s because over the long run, a 100% stock portfolio is very likely to out-perform a portfolio that has a significant allocation to bonds, especially given the current low interest rate environment.
Like most investment decisions, whether to include bonds in your investment portfolio depends on a number of considerations. Generally speaking, I believe bonds should continue to play a role in most (but not all) investors’ portfolios. I also think that at the present time, bonds issued by strong governments with lower duration make a good deal of sense, notwithstanding their lower interest rates.
Lastly, investors who lament about interest rate risk may want to consider laddered certificates of deposit (CDs), ultra-short bond funds, inflation-linked securities, high-dividend paying utility stocks, and real-estate investment trusts (REITs) as possibilities for diversifying the fixed income allocation of their portfolios.
 On occasion, interest rates for longer maturities have fallen below those of short maturities. This market condition is referred to as an 'inverted' yield curve. However, the yield curve inverts only rarely, and when it does, it is a short-lived condition.  1.33% to be precise.  The U.S. government can’t go bankrupt because its debts are denominated in dollars, and theoretically there is no limit on how much money the U.S. Treasury can print and the Federal Reserve can put into circulation.  The change in a bond's price given a change in interest rates is known as its duration.  Treasury Inflation-Protected Security (TIPS) are Treasury bonds whose principal value rises (falls) as inflation rises (falls). Since inflation and rising rates often go hand in hand, TIPS have less interest rate risk than traditional bonds.  An all-stock portfolio may make particular sense for an IRA or 401k for participants who pay little attention to their accounts in the short term. In that case a total stock market ETF, such as Vanguard Total Stock Market ETF (VTI), is worth serious consideration.