Stocks are the unruly kids. Bonds are the adult in the room.

A simple and effective portfolio will typically consist of Canadian companies, US companies, International companies and Canadian bonds. And for sure, you can certainly add more diversification if you like. 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 Growth 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 from various government agencies and companies. The bonds will also be of various lengths (duration) and of various yields.

Bonds are loans, you’re the bank

At the core, bonds are quite simple. You lend money and 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.

Boring but essential

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.

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.

And keep in mind that we will usually employ more than bonds to keep the portfolio in check. We can add gold and commodities and more. Please have a read of the new balanced portfolio.

Stocks and bonds and teeter totters

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. 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 5%. 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. Your less attractive 3% yielding bond goes down in price.

Why bonds change in price

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.

Bonds during higher inflation

We recently experienced a brief period when bonds did not work when stock markets suffered in 2022. That was during the recent inflation spike. When central bankers, including the Bank of Canada, are trying to bring inflation under control, they raise rates in the attempt to lessen consumer spending. They are trying to remove demand for products and services to bring down prices.

They were successful over the last few years; inflation now appears to be under control. It’s likely that bonds will do their thing (go up in price) if we are about to have another recession.

As I have penned extensively on this blog, how we can manage near term high inflation risk by holding dedicated inflation fighters such as the Purpose Real Asset ETF – PRA.TO.

I also like Canadian oil and gas stocks.

Managing portfolio risk

We manage the risks by holding many bonds and we can certainly shape 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.

The broader bond market ETF and types of bonds

Of course you’ll find that iShares fund as a suggestion as the bond component on my ETF Model Portfolio page. That is a wonderful option if you want to hold the greater bond market in one ETF.

Shorter bonds vs longer bonds.

A main distinction is the duration of the bond ETF, that is, a 1-year bond ETF vs a 10-year bond ETF. The shorter bond fund will hold very little price risk. It does not respond much to the change in interest rates. You can even use an ultra-short bond ETF such as the Global X ETF CBIL.TO. It is cash-like. It holds government treasuries so it is described as ‘no risk’.

CBIL and other short term bond funds are a great place to protect your short term spending needs, similar to GICs and savings accounts. That said, CBIL will not go up in price when the stock markets move down. There is no inverse relationship during recessions and major stock market corrections.

A longer duration bond ETF such as iShares XLB.TO will offer more of the traditional bond shock absorber experience for investors. During most corrections these longer bonds will move up considerably when stock markets take a hit. See the chart example above in this post.

Bonds are boring but interesting and essential for most

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. Use the Contact Form on this page.

As always, investing can be simple. Most investors will want or need a well-balanced investment approach that includes those stocks (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.

Why retirees hold bonds, cash and GICs.

Know your risk tolerance level

You can look to the post shown below, for a table that details the ratio of bonds to stocks and how that affects the volatility or risk level of the total portfolio.

The Canadian asset allocation ETFs.

Be sure to understand your risk tolerance and then match your portfolio to your risk level.

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Feel free to ask questions in the comment section, or use that Contact Form to send me (Dale) a question or two. I will be sure to reply.