Tom Roberts: Why everyone needs to own bonds

Everyone should own bonds or bond-like investments, though you might ask why would anyone want to own bonds at this time.

Interest rates are going up and the math says the financial value of bonds will decrease. The value in owning bonds is not just for the known rate of income but also to provide a less-volatile rate of return and to provide stability to a portfolio. Providing stability and helping us deal with our instinctual desire to make the wrong moves at the wrong times may have the most value for investors.

If you are looking to your portfolio to provide income, bonds are a tough place to be these days. Yields are very low on high-credit quality bonds and you can receive more income from equity investments in the form of company stock dividends, Real Estate Investment Trust (REIT) or Master Limited Partnership (MLP) distributions. Higher yields are available on lower quality bonds, though these have volatility risks similar to equities.

So why own bonds? Despite our best efforts, no one knows when, how much or how fast interest rates will increase. These all have a great impact on the change in bond values. If rates increase gradually, such that economic activity and other markets adjust, there is limited impact on a diversified portfolio.

You can also reduce the impact by owning bonds in sectors that are less likely to be impacted by rate changes. These include financially strong municipalities, sectors that are out of favor or those with improving credit quality. Bonds with shorter duration, shorter term to maturity or higher coupon rates also are less affected by interest-rate changes.

Bonds, or bond-like investments, can provide stability to your portfolio, which may keep you from selling or buying at the wrong time.

What if the stock market slides? From 2007-09, the all-stock S&P 500 went down 50 percent and took 35 months to recover its previous value. A 60/40 portfolio made up of the S&P 500 and U.S. Aggregate Bonds went down 32 percent and took 20 months to recover. The lesser portfolio value drop might have kept you invested and benefiting from the current run up.

If you look at the risk taken to the returns achieved, having a more-stable portfolio comes out ahead. You can use the Sharpe Ratio or the Sortino Ratio to evaluate the returns for the risks taken.

All investors have some level of risk where they are comfortable. Beyond that, they will tend to make irrational decisions. You can design portfolios to match risk profile and remain on your long-term plan. Bonds and other moderating, non-correlated investments can help achieve this goal.

The wise investor knows their limitations, time horizon, financial ability to take on risks and “gut check” risk tolerance, and stays within their profile. Even those with long-time horizons and ability to take higher risks can benefit by owning some classes of bonds. For these investors, high-yield bonds may fit well in higher-risk portfolios.

For those looking for a more-secure portfolio, higher-quality bonds can provide reduced risk as your principal is safer.

What are some non-bond options that can achieve the same goals? There are a number of alternative investments or strategies that can help reduce portfolio risk while not being as impacted by interest-rate changes. Floating rate bonds adjust to interest-rate changes similar to an adjustable-rate mortgage. They are generally lower credit quality, so you are trading one risk for another.

REITs and MLPs offer higher yields since the distributions are only taxed once. However, they are equities and the industries are leveraged and influenced by interest rates. A merger and acquisition investment strategy can be owned in a mutual-fund format and offers bond-like returns and volatility.

Other alternatives that might replace bonds include market-neutral, long-short managed futures or funds using a mix of these strategies. More recently, these strategies have become available in easier-to-access formats such as mutual funds or exchange-traded funds. Previously you had to use hedge funds, locked up or higher investments. This does not mean that everyone should use them in place of bonds. Costs tend to be higher than traditional investments and they all have risks.

For many investors, the reason to own bonds is to provide portfolio stability and help stay with your plan. They provide a way to lower overall risk and increase your risk adjusted return. Choosing the proper amount to allocate to bonds means understanding your ability to take on risk and your time horizon.

There are alternative investments that can be used in conjunction with bonds to provide the same benefits without some of the risks associated with bonds. When choosing investments, make sure you understand the pluses and minuses of each, and how they interact with your other investments.

This story was originally published December 5, 2016 at 12:42 PM with the headline "Tom Roberts: Why everyone needs to own bonds."