Stocks are the Unruly Kids. Bonds are the Adult in the Room.

I recently described the ‘Perfect Portfolio’ with the blog This is Easy Street for Canadian Investors. Of course a simple and effective portfolio will typically consist of Canadian companies, US companies, International companies and Canadian bonds.

We likely all understand that the growth engine of the portfolio is the companies or stocks, but what about those bonds? I like to call those bonds shock absorbers; they can be the stabilizers for the portfolio. Bonds can make the roller coaster ride of the stocks a little less scary. We put those stocks and bonds together and we call that a Balanced Portfolio. You can have a very conservative Balanced Portfolio, a somewhat aggressive Balanced Portfolio or a down the middle Balanced Portfolio.

More bonds = more shock absorbers 

What is a bond? A bond is a loan. As an example you might loan the government of Canada $10,000 for 10 years and they will pay you $500 per year for that loan. Of course at that rate the government of Canada is paying you 5% per year. They will pay you that fixed income over the 10 years and after the final interest or coupon payment they will also return your initial $10,000 loan. You might have bonds or loans to various provinces, cities, towns and companies. A corporate bond involves lending monies to companies. A well-balanced bond portfolio will typically include many bonds for various government agencies and companies. The bonds will also be of various lengths (duration) and of various yields.

Many think that bonds are boring, but they are essential building blocks for the portfolios for most investors. If the stocks are the over-emotional and sometimes erratic and uncontrollable children, the bonds are the adult in the room.

Sorry kids, the parents are here to keep you in line.

shutterstock_Kid

Bonds can keep the stocks in line and keep the portfolio in check because the bonds can zig when the stocks zag. Let’s use more childlike analogies, think teeter totter. When stocks go down in price, bonds can go up in price. Here’s an example from my 2013 Seeking Alpha article Portfolio Keeping You Up at Night? Take One of These. This chart demonstrates that teeter totter effect. That’s the stocks going down hard in blue and those bonds going up, in red. Of course, put those two together and you will get a much smoother ride.

So why do bonds change in price? You can trade a bond so there is obviously a buyer and a seller. We know that interest rates can change and that can affect bonds and bond yields available in the marketplace. Think that if you have a 10 year government bond that pays you 3% a year, and then rates change and a similar or exact 10 year government bond is available that now pays 4%. A buyer would obviously choose to buy the higher yielding bond, meaning that you’ll have to put your bond on sale, you’ll have to discount your bond offering.

Or course bonds can also go up in price, as per the above chart. Interest rates could fall, meaning bonds already owned are more attractive than the new lower yielding bonds coming onto the market. You could sell your bonds at a premium, perhaps with a nice profit. Of course, government agencies might lower rates when the economy is faltering, when stocks markets are falling, and that can be beneficial for the bond markets and bond holders. Other factors can also affect bond prices such as the credit rating of the bond issuer.

Keep in mind that there is no guarantee that bonds will go up when stocks go down, but in every North American recession, bond markets rallied. Bonds are usually there when we really need them. As always past performance does not guarantee future results.

At the core, bonds are quite simple. You lend monies you get paid. And like with any subject matter you can dig as deep as you like. Here is a wonderful overview from Vanguard, think of it as everything you ever wanted to know about bonds but were afraid to ask.

And of course, bonds do carry risks. If you take on greater risk you might be offered a greater yield. The risk with a corporate bond is known as default risk, meaning that the company may run into trouble and they will not be able to pay you the interest amount and perhaps they will not be able to return your original loan amount. The good news is that if a company runs into trouble bond holders are paid before the equity holders (those who hold the stock). Bond holders are first in line.

We manage the risks by holding many bonds and we can certainly shade the investment so that we are only holding higher quality or less risky bonds. A broad-based bond fund will mostly hold higher quality bonds. Many types of government bonds are known as ‘risk free’ as the government agency can raise taxes to pay you back, they can borrow more money to pay you back, or essentially print money to pay you back. A bond investment such as the iShares Core Canadian Bond Universe ETF holds a nice collection of over 1200 government and corporate bonds. All of the bonds are listed as Investment Grade. This fund is low risk.

Of course you’ll find that iShares fund as a suggestion as the bond component on my ETF Model Portfolio page. You can certainly find or use different bond options. You can take on more risk such as with iShares Hybrid Bond Fund that only invests in corporate bonds. You can invest in bond ladders, you can find funds that only invest in government bonds. You can also choose to invest in funds that only hold shorter duration bonds (1-3 years), or longer duration bonds (10-20 years or more).

If you have any questions on the different types of bond options and why or how we might use them, please send me a note. That said, many pure intelligent indexers will suggest that you keep it simple and use that meat and potatoes core bond fund approach.

As always, investing can be simple. Most investors will want or need a well-balanced investment approach that includes those stock kids and adult-like bonds. That said, some investors are very aggressive and they’ll go that all stock route. Just remember, those stocks have been known to get out of control when there’s no adult in the room.

Know your risk tolerance level.

Thanks for reading. Please help your fellow Canadians who pay the highest mutual fund fees in the developed world and hit the share buttons at the bottom of this blog.

Dale @ cutthecrapinvesting@gmail.com

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